Interim Financial Statements 1 January - 30 September 2012 Unaudited
Arion Bank Borgartún 19 105 Reykjavík Iceland
Reg. no. 581008 - 0150 Contents
page page Endorsement and Statement by the Board of Directors and the CEO ...... 3-4 Interim Statement of Changes in Equity ...... 7
Interim Statement of Comprehensive Income ...... 5 Condensed Interim Statement of Cash Flows ...... 8
Interim Statement of Financial Position ...... 6 Notes to the Interim Financial Statements ...... 9-44
Arion Bank Interim Financial Statements 30 September 2012 ______2 ______Endorsement and Statement by the Board of Directors and the CEO
The Interim Financial Statements of Arion Bank for the period ended 30 September 2012 include the Interim Financial Statements of Arion Bank ("the Bank") and its subsidiaries, together referred to as "the Group".
Arion Bank is a group of financial undertakings which provide comprehensive financial services to companies, institutions and private customers. These services include corporate banking, retail banking, investment banking and asset management and comprehensive wealth management for private banking clients.
Kaupskil ehf., a company owned by Kaupthing hf. (formerly Kaupthing Bank hf.), holds 87% of the shares in Arion Bank. The remaining shareholding of 13% is held by Icelandic State Financial Investments on behalf of the Icelandic government.
Operations during the period Net earnings amounted to ISK 14,537 million for the period ended 30 September 2012. Total equity amounted to ISK 128,432 million at the end of the period, including share capital amounting to ISK 2,000 million. The capital adequacy ratio of the Group, calculated according to the Act on Financial Undertakings, was 22.5%. By law this ratio is required to be no lower than 8.0%, but the Icelandic Financial Supervisory Authority ("FME") requires it to be no less than 16%. The Group’s liquidity position was strong with the liquidity ratio and cash ratio being 31% and 18% respectively at the end of the period. This compares favourably with the regulatory minimum of 20% and 6% respectively.
Arion Bank generally performed well during the period and core banking activities continued to yield strong results. The same applied to core subsidiaries.
Deposits in domestic banks have declined gradually and are expected to continue to do so in the near future, the main drivers being new investment opportunities for individuals and institutional investors. Arion Bank is fully aware of this trend and continues to strengthen and diversify its funding base. To that effect, the Bank, on 17 February, issued its first covered bonds under its EUR 1 billion Covered Bond Programme. The issue was ISK 2.5 billion index-linked, with a final maturity in 2034, targeted towards Icelandic institutional investors. Arion Bank was also the first Icelandic bank to issue fixed rate, non index-linked, covered bonds. In May and June the Bank issued a total of ISK 2.5 billion 6.5% fixed rate covered bonds maturing in 2015. In April the Icelandic rating agency Reitun ehf. published its B+ rating of Arion Bank's senior unsecured bonds issuance. This rating is two notches below the rating of the Republic of Iceland. The Agency furthermore issued a rating of A to Arion Bank's covered bond issuance, which is at par with the rating of the Republic of Iceland. The Bank has placed emphasis on selling its shareholding in legal entities which were acquired as a result of a foreclosure. During the first two quarters of the year the Bank sold a large part of its shareholding in Hagar hf. or 15.7% effective share. The remaining shareholding in Hagar is classified as a trading asset. After receiving the approvals of the Icelandic Competition Authority the sale of B.M. Vallá ehf. was finalized in May, the sale of 38.9% share in N1 hf. in June and the sale of Penninn á Íslandi ehf. in August. In June the Bank sold its 20% shareholding in Ölgerdin Egill Skallagrímsson ehf. and in July a Finnish subsidiary of Fram Foods ehf., Boyfood OY was sold.
Progress has been made toward simplifying the Group structure by merging subsidiaries into the Bank and by liquidating several subsidiaries. The main entities merged into the Bank were Verdis ehf. and Sparisjódur Ólafsfjardar, both wholly owned by the bank. The quality of the Bank‘s balance sheet continues to improve. The recovery work on loans to larger corporations is largely completed and work continues with SME‘s and individuals. On 15 February 2012, the Supreme Court passed a judgment regarding interest on FX linked loans, adding uncertainty regarding the book value of foreign currency lending. The ruling was not decisive enough for all disputed aspects of FX loans and further clarification from Court rulings was deemed necessary. Recent rulings have significantly reduced the uncertainties related to the February judgment and the Group has announced that certain currency-linked loans will be recalculated. Further discussion about the legality of foreign currency loans is contained in Note 52.
On 6 November the FME published its conclusions concerning a valuation of Arion Bank's loan book. The sample used in the valuation was 43% of the corporate loans, and the main findings were that there is no indication of any overvaluation of the Bank's loan book.
There continue to be positive signs in the Icelandic economy which is forecasted to grow by 2.7% this year. A number of the Group's customers have experienced growth in their operations, a trend underlined in the Bank's marketing. A key step in customer interface was taken by the Bank when the Arion App was launched in August and in September motor financing was added to the product portfolio. The Group has performed strongly. It has been able to attract existing pension funds to its asset management services as well as to add valuable customers to the corporate loan book. The primary focus in investment banking activities has until recently been on selling assets held by the Group but now when this assignment is coming to an end the focus has shifted to customer originated projects which are at different stages in their process.
Arion Bank Interim Financial Statements 30 September 2012 ______3 ______Endorsement and Statement by the Board of Directors and the CEO
Statement by the Board of Directors and the CEO The Interim Financial Statements for the period ended 30 September 2012 have been prepared in accordance with International Financial Reporting Standard (IAS 34 Interim Financial Reporting ) as adopted by the EU. It is our opinion that the Interim Financial Statements give a true and fair view of the financial performance of the Group for the period ended 30 September 2012, its financial position as at 30 September 2012 and its cash flows for the period ended 30 September 2012. Further, in our opinion the Interim Financial Statements and the Endorsement of the Board of Directors and the CEO give a true and fair view of the development and performance of the Group's operations and its position and describes the principal risks and uncertainties faced by the Group.
The Board of Directors and the CEO have today discussed the Interim Financial Statements of Arion Bank for the period ended 30 September 2012 and confirm them by means of their signatures.
Reykjavík, 28 November 2012
Board of Directors
Monica Caneman Chairman
Agnar Kofoed-Hansen Gudrún Johnsen Måns Höglund
Freyr Thórdarson Jón G. Briem
Chief Executive Officer
Höskuldur H. Ólafsson
Arion Bank Interim Financial Statements 30 September 2012 ______4 ______Interim Statement of Comprehensive Income for the Period from 1 January to 30 September 2012
Notes 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9.
Interest income ...... 43,463 34,672 11,310 11,052 Interest expense ...... (23,329) (17,836) (5,056) (5,376) Net interest income...... 12 20,134 16,836 6,254 5,676
Increase in book value of loans and receivables ...... 13 8,073 29,795 905 457 Impairment of loans and receivables ...... 14 (7,594) (6,443) (2,958) (642) Changes in compensation instrument ...... 15 - (19,593) - - Net interest income less valuation changes on loans and receivables...... 20,613 20,595 4,201 5,491
Fee and commission income ...... 12,089 12,300 4,121 3,921 Fee and commission expense ...... (4,036) (4,726) (1,406) (1,446) Net fee and commission income...... 16 8,053 7,574 2,715 2,475
Net financial income (expense) ...... 17-20 491 348 161 386 Net foreign exchange gain (loss) ...... 21 559 1,979 708 2 Share of profit or loss of associates ...... 39 13 (1) 6 - Other operating income ...... 22 4,630 3,478 1,631 1,161 Operating income...... 34,359 33,973 9,422 9,515
Salaries and related expense ...... 24 (8,813) (8,221) (2,644) (2,705) Administration expense ...... (6,055) (5,400) (1,908) (1,632) Depositors' and investors' guarantee fund ...... 50 (683) (875) (238) (318) Depreciation and amortisation ...... (714) (655) (251) (225) Other operating expense ...... 25 (609) (624) (189) (160) Earnings before tax...... 17,485 18,198 4,192 4,475
Income tax expense ...... 26 (3,375) (3,079) (462) (562) Bank Levy ...... 27 (771) (684) (261) (238)
Net earnings from continuing operations...... 13,339 14,435 3,469 3,675
Net gain (loss) from discontinued operations, net of tax ...... 28 1,198 (787) (181) (219)
Net earnings...... 14,537 13,648 3,288 3,456
Attributable to: Shareholders of Arion Bank ...... 14,176 13,046 3,124 3,221 Non-controlling interest ...... 361 602 164 235
Net earnings...... 14,537 13,648 3,288 3,456
Other comprehensive income
Exchange difference on translating foreign subsidiaries ...... - 112 - (2) Total comprehensive income for the period...... 14,537 13,760 3,288 3,454
Earnings per share from continuing operations Basic and diluted earnings per share from continuing operations attributable to the shareholders of Arion Bank (ISK) ...... 29 6.49 6.92 1.65 1.72
The notes on pages 10 to 44 are an integral part of these Interim Financial Statements.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______5 ______Interim Statement of Financial Position as at 30 September 2012
Assets Notes 30.09.2012 31.12.2011 30.09.2011
Cash and balances with Central Bank ...... 30 16,026 29,200 38,000 Loans and receivables to credit institutions ...... 31-32 88,007 69,103 60,422 Loans and receivables to customers ...... 33-34,55 572,484 561,550 444,074 Bonds and debt instruments ...... 35-36 119,697 140,568 158,549 Shares and equity instruments with variable income ...... 35 15,860 14,045 14,324 Derivatives ...... 35,46 969 674 1,057 Securities used for hedging ...... 35 1,398 2,372 365 Investment property ...... 38 28,171 27,100 26,912 Investments in associates ...... 39 3,024 2,987 2,756 Property and equipment ...... 6,147 6,271 6,433 Intangible assets ...... 5,102 4,765 4,681 Tax assets ...... 40 475 724 377 Non-current assets and disposal groups held for sale ...... 41 13,711 23,886 40,193 Other assets ...... 42 5,174 8,876 24,909
Total Assets 876,245 892,121 823,052
Liabilities
Due to credit institutions and Central Bank ...... 35 16,459 16,160 30,209 Deposits ...... 35 454,405 489,995 511,473 Financial liabilities at fair value ...... 35 11,122 4,907 6,111 Tax liabilities ...... 40 3,220 3,421 7,085 Non-current liabilities and disposal groups held for sale ...... 41 2,683 4,950 11,901 Other liabilities ...... 43 35,010 38,822 36,421 Borrowings ...... 35,44 192,412 187,203 67,317 Subordinated liabilities ...... 35,45 32,502 32,105 31,875
Total Liabilities 747,813 777,563 702,392
Equity
Share capital ...... 47 2,000 2,000 2,000 Share premium ...... 47 73,861 73,861 73,861 Other reserves ...... 48 1,637 1,637 1,637 Retained earnings ...... 47,126 32,950 35,504 Total Shareholders' Equity 124,624 110,448 113,002
Non-controlling interest ...... 3,808 4,110 7,658
Total Equity 128,432 114,558 120,660
Total Liabilities and Equity 876,245 892,121 823,052
The notes on pages 10 to 44 are an integral part of these Interim Financial Statements.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______6 ______Interim Statement of Changes in Equity for the Period from 1 January to 30 September 2012
Total Share capital Share- Non- and share Other Retained holders' controlling Total premium reserves earnings equity interest equity
Changes in equity from 1 January to 30 September 2012:
Equity 1 January 2012 ...... 75,861 1,637 32,950 110,448 4,110 114,558 Total comprehensive income for the period attributable to the shareholders of Arion Bank ...... 14,176 14,176 14,176 Total comprehensive income for the period attributable to the non-controlling interest ...... 361 361 Acquisition of non-controlling interests ...... (664) (664) Equity 30 September 2012 ...... 75,861 1,637 47,126 124,624 3,808 128,432
Changes in equity from 1 January to 30 September 2011:
Equity 1 January 2011 ...... 75,861 1,525 28,531 105,917 3,619 109,536 Dividend paid ...... (6,073) (6,073) (6,073) Total comprehensive income for the period attributable to the shareholders of Arion Bank ...... 112 13,046 13,158 13,158 Total comprehensive income for the period attributable to the non-controlling interest ...... 602 602 Disposal of non-controlling interests ...... 3,437 3,437 Equity 30 September 2011 ...... 75,861 1,637 35,504 113,002 7,658 120,660
The notes on pages 10 to 44 are an integral part of these Interim Financial Statements.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______7 ______Condensed Interim Statement of Cash Flows for the Period from 1 January to 30 September 2012
Notes 2012 2011 1.1.-30.9. 1.1.-30.9.
Cash flows from (used in) operating activities
Earnings from continuing operations before tax ...... 17,485 18,198
Adjustments to reconcile earnings before income tax to net cash from (used in) operating activities: Non-cash items included in net earnings before income tax and other adjustments ...... (26) (1,377) Changes in operating assets and liabilities ...... 54 (31,859) (15,893) Income taxes paid ...... (3,326) (544) Net cash from (used in) operating activities (17,726) 384 Net cash from (used in) investing activities 15,104 4,792 Net increase (decrease) in cash and cash equivalents ...... (2,622) 5,176 Cash and cash equivalents at beginning of the period ...... 82,815 72,797 Cash and cash equivalents acquired through business combinations ...... - 5 Effect of exchange rate changes on cash and cash equivalents ...... 2,322 1,234 Cash and cash equivalents at the end of the period ...... 82,515 79,212
Cash and cash equivalents comprises
Cash in hand and demand deposits ...... 16,026 38,000 Due from credit institutions ...... 74,051 49,001 Mandatory reserve with Central Bank ...... (7,562) (7,789) Cash and cash equivalents at period-end 82,515 79,212
Non-cash investing and financing transactions:
Tier II subordinated notes issued in settlement of dividend ...... - (6,073) Change in retained earnings for settlement of dividend with Icelandic State ...... - 6,073
The notes on pages 10 to 44 are an integral part of these Interim Financial Statements.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______8 ______Notes to the Interim Financial Statements Contents
page page
Accounting Policies Tax assets and tax liabilities ...... 27 General information ...... 10 Non-current assets and disposal groups held for sale ...... 27 Significant accounting policies ...... 10-12 Other assets ...... 28 Changes within the Group ...... 12 Other liabilities ...... 28 Borrowings ...... 29 Operating Segment Reporting 13-14 Subordinated liabilities ...... 29 Derivatives ...... 29 Quarterly Statements 15 Equity Notes to the Interim Statement of Comprehensive Income Share capital and share premium ...... 30 Net interest income ...... 16 Other reserves ...... 30 Increase in book value of loans and receivables ...... 16 Impairment of loans and receivables ...... 16 Off Balance Sheet information Changes in compensation instrument ...... 17 Obligations ...... 30 Net fee and commission income ...... 17 Assets under management and under custody ...... 30 Net financial income ...... 18 Contingent liabilities ...... 31-32 Net foreign exchange gain (loss) ...... 18 The uncertainty regarding the book value Other operating income ...... 19 of foreign currency lending ...... 32-33 Personnel and salaries ...... 19 Other operating expense ...... 20 Notes to the Condensed Interim Statement of Cash Flow 34 Tax expense ...... 20 Net gain (loss) from discontinued operations Risk Management Disclosures net of tax ...... 21 Credit risk ...... 35-37 Earnings per share ...... 21 Market risk ...... 38-42 Liquidity risk ...... 42 Notes to the Interim Statement of Financial Position Capital Adequacy and ICAAP Strategy ...... 43 Cash and balances with Central Bank ...... 21 Loans and receivables to credit institutions ...... 22 Other information Loans and receivables to customers ...... 22 Related parties ...... 43-44 Financial assets and liabilities ...... 23-26 Events after the Balance Sheet date ...... 44 Investment property ...... 26 Subsidiaries ...... 44 Investment in associates ...... 27
Arion Bank Interim Financial Statements 30 September 2012 ______9 ______Notes to the Interim Financial Statements
Accounting Policies
General information
1. Reporting entity Arion banki hf., the Parent Company, was established 18 October 2008 and is incorporated and domiciled in Iceland. The registered office of Arion banki hf. is located at Borgartún 19, Reykjavík. The Interim Financial Statements for the period ended 30 September 2012 comprise the Parent Company and its subsidiaries (together referred to as "the Group"). The Group offers integrated financial services to companies, institutional investors and individuals. These services include corporate banking, retail banking, investment banking services and asset management and comprehensive wealth management for private banking clients.
The Interim Financial Statements were approved and authorised for issue by the Board of Directors of Arion Bank on 28 November 2012.
2. Basis of preparation
a) Statement of compliance The Interim Financial Statements have been prepared in accordance with International Financial Reporting Standard IAS 34, Interim Financial Reporting as endorsed by the European Union. The Interim Financial Statements do not include all the information and disclosures required in the annual financial statements, and should be read in conjunction with Arion Bank´s annual Financial Statements for the year 2011. The statements are available at Arion Bank´s website www.arionbanki.is. b) Basis of measurement The Interim Financial Statements are prepared on the historical cost basis except for the following: – Financial assets/liabilities held for trading are measured at fair value; – Financial assets/liabilities designated at fair value through profit and loss are measured at fair value; – Investment properties are measured at fair value; and Non-current assets (or disposal groups) classified as held for sale are stated at the lower of their carrying amount and fair value less costs to sell. Immediately before the initial classification, or where the assets and liabilities are not within the scope of IFRS 5, the carrying amounts are measured in accordance with applicable IFRSs.
c) Functional and presentation currency The Interim Financial Statements are presented in Icelandic króna (ISK), which is the Parent Company's functional currency, rounded to the nearest million unless otherwise stated.
d) Use of estimates and judgements The preparation of the Interim Financial Statements requires management to make judgements, estimates and assumptions that affect the reported amounts of assets, liabilities, contingent liabilities as well as income and expenses in the Interim Financial Statements presented. Use of available information and application of judgement are inherent in the formation of estimates. Actual results in the future could differ from such estimates and the differences may be material to the Interim Financial Statements. Estimates and underlying assumptions are reviewed on an on going basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised and in any future periods affected. Judgements made by management that have a significant effect on the Interim Financial Statements and estimates with a significant risk of material adjustment within the next financial year are discussed in Note 4 in these Interim Financial Statements and in the annual Financial Statements 2011.
Significant accounting policies The accounting policies adopted in the preparation of these Interim Financial Statement are consistent with those followed in the preparation of the Group's annual Financial Statements for the year ended 31 December 2011.
3. Going concern assumption The Group's management has made an assessment of the ability to continue as a going concern and is satisfied that the Group has the resources to continue. In making this assessment management has taken into consideration the risk exposures facing the Group which are further described in the Risk Management Disclosures.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______10 ______Notes to the Interim Financial Statements
4. Critical accounting estimates and judgements in applying accounting policies The Group makes estimates and assumptions that affect the reported amounts of assets and liabilities. Estimates and judgements are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances.
These disclosures supplement the risk management disclosures, provided elsewhere in these Interim Financial Statements. Key sources of estimation uncertainty
i) Impairment losses on loans and receivables The Group reviews its loan portfolios to assess impairment at least on a quarterly basis. In determining whether an impairment loss should be recorded in the Statement of Comprehensive Income, the Group makes judgements as to whether there is any observable data indicating that there is a measurable decrease in the estimated future cash flows from a portfolio of loans before the decrease can be identified with an individual loan in that portfolio. This evidence may include observable data indicating that there has been an adverse change in the payment status of borrowers in a group, or national or local economic conditions that correlate with defaults on assets in the group. Management uses estimates based on historical loss experience for assets with credit risk characteristics and objective evidence of impairment similar to those in the portfolio when scheduling its future cash flows. The methodology and assumptions used for estimating both the amount and timing of future cash flows are reviewed regularly to reduce any differences between loss estimates and actual loss experience.
ii) Foreign currency linked loans The Group is evaluating the impact of the Supreme Court judgment of 15 February 2012 on the currency-linked loan portfolio. The Group’s preliminary evaluation is that currency linked loans can be recalculated with the non-indexed interest rate set by the Central Bank of Iceland. However, if the borrower has paid according to the Bank‘s payment slips, then the Bank can not normally claim a larger amount of interest on the loan than the interest the borrower has actually paid. As set out in Note 53 of these Interim Financial Statements, the Group recognised impairment of the currency linked loan portfolio at period- end for the estimated loss arising from the above judgment. The Group remains exposed to significant uncertainty regarding foreign currency linked loans arising from firstly, uncertainty over its interpretation of this judgment and secondly, uncertainty over the outcome of future legal decisions and new or amended government legislation. Management judgment is required in the determination of the individual borrowers that require recalculation, and the estimated loss is based on assumptions that may be revised when it becomes clear how to interpret the Supreme Court‘s judgement. In addition, the outcome of future legal decisions and new or amended government legislation may require recalculation of other categories of foreign currency loans that the Group has not previously considered as vulnerable. This will be determined by future court rulings and government actions, for which it is not currently possible to predict an outcome. iii) Fair value of financial instruments The fair value of financial instruments that are not quoted in active markets are determined by using valuation techniques. Where valuation techniques (for example, models) are used to determine fair values, they are validated and periodically reviewed by qualified personnel independent of the area that created them. All models are certified before they are used, and models are calibrated to ensure that outputs reflect actual data and comparative market prices. To the extent practical, models use only observable data, however areas such as credit risk (both own and counterparty), volatilities and correlations require management to make estimates. Changes in assumptions about these factors could affect reported fair value of financial instruments. iv) Assets classified as held for sale The Group classifies assets as held for sale if the assets are available for immediate sale in their present condition subject only to terms that are usual and customary for sales of such assets and the sale is considered highly probable. For the sale to be highly probable management must be committed to sell the assets and be actively looking for a buyer, the assets must be actively marketed at a price that is reasonable in relation to their fair value and the sale is expected to be completed within one year. An extension of the period required to complete a sale does not preclude an asset or disposal group from being classified as held for sale if the delay is caused by events or circumstances beyond the Group's control and there is sufficient evidence that the Group remains committed to its plan to sell the assets or disposal groups.
When classifying assets as held for sale the Group has determined that the requirements of IFRS 5 have been met.
As set out in Note 21 in the annual Financial Statements for the year 2011, disposal groups being legal entities acquired exclusively with view to resale are measured at the lower of carrying amount and fair values less costs to sell. For the most part, fair values at the date of classification of these legal entities were calculated using valuation models based on discounted future cash flows that incorporated significant non-market observable inputs and assumptions. The use of reasonably possible alternative inputs and assumptions to these models, in particular changes to the discount rate employed (representing the required rate of return on equity), would have a significant impact on the fair value of these disposal groups.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______11 ______Notes to the Interim Financial Statements
4. cont. v) Fair value of Investment Property As the property market in Iceland is relatively inactive and assets are often quite dissimilar it is difficult to obtain reliable estimates of fair values of investment properties. The international financial crises and the financial crisis in Iceland had significant influence on the real estate market in Iceland. The effects of that resulted in a relatively passive market and with disparate properties on the market it can be complicated to use prices from recent market transactions in order to determine values of comparable properties. This being the case there is great uncertainty about the actual fair value of the properties. vi) Intangible assets The value of intangible assets with indefinite useful lives is not amortised, but the assets are tested for impairment at least once a year.
Changes within the Group
5. Merger of entities The boards of Arion Bank and the Bank´s wholly owned subsidiary Verdis hf. approved the merger of these two entities. On 29 June 2012 FME approved the merger. The merger took effect from 1 January 2012.
The boards of Arion Bank and the Bank´s wholly owned subsidiary Sparisjódur Ólafsfjardar approved the merger of these two entities. On 14 September 2012 FME approved the merger. The merger took effect from 1 January 2012. The subsidiary Ekort ehf. was merged into Arion Bank 1 January 2012. Prior to the merger part of the operation of Ekort ehf. was transferred to Einkaklúbburinn ehf. which is a new subsidiary of Arion Bank.
6. Acquisition of mortgage portfolio At year-end 2011 Arion Bank and Kaupthing hf. reached agreement for Arion Bank to acquire a mortgage portfolio which has been managed in a special fund owned by Kaupthing hf. The agreement also specifies that the deal is funded by the assumption of covered bonds by Arion Bank. Under the agreement Arion Bank replaced Kaupthing hf. as issuer of the covered bonds. The covered bonds will be listed on NASDAQ OMX Iceland in the fourth quarter of 2012. Through this acquisition total assets of the Group increased by ISK 94.4 billion and total liabilities increased by ISK 96.7 billion.
7. Acqusition of subsidiaries In April 2012 the Group acquired a further 7.2% share in Valitor Holding hf. After the acquisition the Group holds 60.8% share in Valitor Holding hf.
8. Disposal of subsidiaries The subsidiaries AB-fjárfestingar ehf., ENK 1 ehf. and Vesturland ehf. were liquidated in the first quarter of 2012. In October 2011 Eignabjarg ehf. signed an agreement for the sale of its 100% shareholding in B.M. Vallá ehf., which was approved by the Icelandic Competition Authority in April 2012. B.M. Vallá ehf. was classified as non-current assets and disposal groups classified as held for sale at year-end 2011. The effects from the sale of this entity has minor effects on the Statement of Comprehensive income in the second quarter of 2012.
In June 2012 Eignabjarg ehf. signed an agreement for the sale of its 100% shareholding in Penninn á Íslandi ehf. Approval from the Icelandic Competition Authority was obtained in August 2012. Penninn á Íslandi ehf. was classified as non-current assets and disposal groups classified as held for sale at year-end 2011. The effects from the sale of this entity has minor effects on the Statement of Comprehensive income.
On 3 July 2012 Fram Foods ehf. sold its subsidiary Boyfood Oy in Finland. Fram Foods ehf. is a wholly owned subsidiary of Eignabjarg ehf. Fram foods Oy was classified as non-current assets and disposal groups classified as held for sale at year-end 2011. The effects from the sale of this entity has minor effects on the Statement of Comprehensive income.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______12 ______Notes to the Interim Financial Statements
Operating Segment Reporting
9. Segment information is presented in respect of the Group's operating segments based on the Group´s management and internal reporting structure. Segment performance is evaluated based on earnings before tax.
Inter segment pricing is determined on an arm's length basis. Business segments pay and receive interest to and from Treasury on an arm's length basis to reflect the allocation of capital and funding cost. Segment capital expenditure is the total cost incurred during the period to acquire property and equipment and intangible assets.
Operating segments The Group comprises six main operating segments:
Corporate Banking serves large enterprises and professional investors. The role of the division is to provide universal financial services as well as tailored services to meet the needs of each customer. Corporate Banking is divided into a Corporate Banking unit, Factoring services and a Corporate Recovery unit. Corporate Banking and Factoring together provide a wide range of credit solutions while the Recovery unit is responsible for the financial restructuring of companies which need to reorganise their capital structure.
Retail Banking, Arion Bank Mortgages Institutional Investor Fund (ABMIIF) and AFL sparisjódur provide a comprehensive range of services, including advice on deposits and loans, savings, payment cards, pension savings, insurance, securities, funds and more. To maximize operational efficiency the branch network is divided into seven clusters, with the smaller branches capitalizing on the strength of larger units within each cluster. Customers of Retail Banking's 25 branches all around Iceland are over 100,000.
Asset Management and Stefnir hf. manage assets on behalf of its clients, who include institutional investors, corporations, high net wealth clients and retail investors. The entities offer clients variety of mutual funds, alternative vehicles, pension plan schemes and customized asset allocation strategies designed to meet the diverse needs of investors. The subsidiary Stefnir operates the fund management business.
Investment Banking is divided into Corporate Finance, Capital Markets and Research. Corporate Finance provides M&A advisory services and capital markets transaction services to corporate clients and investors. Capital Markets provides securities brokerage and FX sales for institutional investors and corporate clients. Research is split into Equity, Fixed Income and Macro Analysis with clients such as asset management companies, institutional investors, and other divisions of the Group.
Treasury is responsible for the Bank’s liquidity management as well as currency and interest rate management. The other main functions of Treasury are the internal pricing of interest rates and currency, liaison with other financial institutions, Proprietary trading and market making in domestic securities and currencies.
Other Divisions and Subsidiaries include Proprietary trading and the subsidiaries Eignabjarg ehf., Landey ehf., Landfestar ehf., Okkar líftryggingar hf., Valitor holding hf. and other smaller entities of the Group. Headquarters: Overhead, Risk Management, Finance, Legal, Operations, Corporate Development and activities of other non-core entities.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______13 ______Notes to the Interim Financial Statements
10. Summary of the Group's business segments:
Asset Other Managem. Divisions Headquart. 1.1.-30.9.2012 Corporate Retail and Investment and and Banking Banking Stefnir Banking Treasury Subsidiaries Elimination Total Net interest income ...... 8,131 7,507 1,609 41 3,993 (1,107) (40) 20,134 Other income ...... 1,954 (695) 1,714 4,168 (248) 6,709 623 14,225 Operating income ...... 10,085 6,812 3,323 4,209 3,745 5,602 583 34,359 Operating expense ...... (435) (3,982) (782) (423) (130) (3,458) (7,664) (16,874) Allocated cost ...... (1,390) (3,356) (577) (456) (533) (43) 6,355 - Earnings before tax ...... 8,260 (526) 1,964 3,330 3,082 2,101 (726) 17,485
Net seg. rev. from ext. customers ...... 16,848 13,649 253 4,142 (8,173) 7,126 514 34,359 Net seg. rev. from oth. segments ...... (6,763) (6,837) 3,070 67 11,918 (1,524) 69 - Operating income ...... 10,085 6,812 3,323 4,209 3,745 5,602 583 34,359
Depreciation and amortisation ...... - 127 - - - 153 434 714
Total assets 30.09.2012 ...... 264,011 312,157 4,072 19,263 192,168 84,574 - 876,245 Allocated equity 30.09.2012 ...... 42,241 26,078 3,084 3,082 42,243 11,704 - 128,432
1.1.-30.9.2011
Net interest income ...... 8,929 9,445 1,065 (44) (344) (1,976) (239) 16,836 Other income ...... 7,992 (771) 1,118 1,441 (961) 7,581 737 17,137 Operating income ...... 16,921 8,674 2,183 1,397 (1,305) 5,605 498 33,973 Operating expense ...... (358) (4,035) (732) (505) (153) (3,672) (6,320) (15,775) Allocated cost ...... (1,079) (3,177) (607) (156) (482) (212) 5,713 - Earnings before tax ...... 15,484 1,462 844 736 (1,940) 1,721 (109) 18,198
Net seg. rev. from ext. customers ...... 18,941 5,197 (447) 1,340 (1,003) 7,511 2,434 33,973 Net seg. rev. from oth. segments ...... (2,020) 3,477 2,630 57 (302) (1,906) (1,936) - Operating income ...... 16,921 8,674 2,183 1,397 (1,305) 5,605 498 33,973
Depreciation and amortisation ...... - 123 - - - 158 374 655
Total assets 31.12.2011 ...... 271,208 299,207 3,621 16,477 207,099 94,509 - 892,121 Allocated equity 31.12.2011 ...... 43,297 32,580 2,673 1,269 18,062 16,677 - 114,558
The vast majority of the revenues from external customers is attributable to customers in Iceland. Discontinued operations are excluded from the segmental information.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______14 ______Notes to the Interim Financial Statements
Quarterly Statements
11. Operations by quarters:
2012 Q3 Q2 Q1 Total Net interest income ...... 6,254 7,666 6,214 20,134 Increase in value of loans and receivables ...... 905 7,049 119 8,073 Impairment on loans and receivables ...... (2,958) (4,441) (195) (7,594) Net fee and commission income ...... 2,715 3,002 2,336 8,053 Net financial income (expense) ...... 161 (16) 346 491 Net foreign exchange gain (loss) ...... 708 (1,232) 1,083 559 Other operating income ...... 1,637 2,054 952 4,643 Operating income ...... 9,422 14,082 10,855 34,359 Salaries and related expense ...... (2,644) (3,124) (3,045) (8,813) Administration expense ...... (2,397) (2,495) (2,560) (7,452) Other operating expense ...... (189) (223) (197) (609) Earnings before tax ...... 4,192 8,240 5,053 17,485 Income tax expense ...... (462) (1,852) (1,061) (3,375) Bank Levy ...... (261) (242) (268) (771) Net earnings from continuing operations ...... 3,469 6,146 3,724 13,339 Net gain (loss) from discontinued operations, net of tax ...... (181) 652 727 1,198 Net earnings ...... 3,288 6,798 4,451 14,537
2011
Net interest income ...... 5,676 5,274 5,886 16,836 Increase in value of loans and receivables ...... 457 27,281 2,057 29,795 Impairment on loans and receivables ...... (642) (6,241) 440 (6,443) Changes in compensation instrument ...... - (16,683) (2,910) (19,593) Net fee and commission income ...... 2,475 2,607 2,492 7,574 Net financial income (expense) ...... 386 (767) 729 348 Net foreign exchange gain (loss) ...... 2 2,289 (312) 1,979 Other operating income ...... 1,161 1,217 1,099 3,477 Operating income ...... 9,515 14,977 9,481 33,973 Salaries and related expense ...... (2,705) (2,858) (2,658) (8,221) Administration expense ...... (2,175) (2,458) (2,297) (6,930) Other operating expense ...... (160) (298) (166) (624) Earnings before tax ...... 4,475 9,363 4,360 18,198 Income tax expense ...... (562) (1,472) (1,045) (3,079) Bank Levy ...... (238) (379) (67) (684) Net earnings from continuing operations ...... 3,675 7,512 3,248 14,435 Net gain (loss) from discontinued operations, net of tax ...... (219) (286) (282) (787) Net earnings ...... 3,456 7,226 2,966 13,648
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______15 ______Notes to the Interim Financial Statements
Notes to the Interim Statement of Comprehensive Income Net interest income
12. Interest income and expense is specified as follows:
2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Cash and balances with Central Bank ...... 461 381 160 134 Loans and receivables ...... 36,121 28,036 8,643 8,899 Securities ...... 6,530 5,722 2,366 1,923 Compensation instrument ...... - 322 - - Other ...... 351 211 141 96 Interest income ...... 43,463 34,672 11,310 11,052
Deposits ...... 12,943 14,243 3,322 4,088 Borrowings ...... 9,095 1,966 1,344 651 Subordinated loans ...... 1,169 1,404 357 433 Other ...... 122 223 32 204 Interest expense ...... 23,329 17,836 5,056 5,376
Net interest income ...... 20,134 16,836 6,254 5,676
Interest income from assets at fair value ...... 6,530 6,044 2,366 1,923 Interest income from assets not at fair value through profit or loss ...... 36,934 28,628 8,945 9,129 Interest expense from liabilities not at fair value through profit or loss ...... (23,330) (17,836) (5,057) (5,376) Net interest income ...... 20,134 16,836 6,254 5,676
Increase in book value of loans and receivables
13. The increase in book value of loans and receivables is determined in accordance with the accounting policy presented in the annual Financial Statements 2011. Increase in book value of loans and receivables consists of adjustment to reflect actual and estimated cash flows.
Impairment of loans and receivables
14. Impairment of loans and receivables is specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Impairment of loans and receivables to credit institutions ...... 3 (40) 5 408 Impairment of loans and receivables to customers ...... 7,591 6,483 2,953 234 Impairment of loans and receivables ...... 7,594 6,443 2,958 642
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______16 ______Notes to the Interim Financial Statements
Changes in compensation instrument
15. The compensation instrument was originated due to the difference in the fair value of the transferred assets, liabilities and contingent liabilities from Kaupthing hf. to Arion Bank in 2008. On 30 June 2011 a Settlement and release of claims agreement was signed by Arion Bank and Kaupthing hf. to finalize a settlement of the Compensation Instrument and various other claims lodged against Kaupthing hf. by Arion Bank. By signing the agreement the Compensation Instrument was terminated and neither party has any payment obligations towards the other under the Instrument. For further information regarding the Compensation instrument see Arion Banks' annual Financial Statements for the year 2011.
Compensation instrument is specified as follows: 31.12.2011 Balance 1 January 2011 ...... 24,188 Changes due to the Escrow and Contingent Value Rights Agreement Continuing operations ...... (19,593) Discontinued operations ...... 1,578 Accrued interest ...... 322 Foreign exchange rate differences ...... 325 Assets and liabilities upon settlement ...... (6,820) Balance 31 December 2011 ...... -
Net fee and commission income
16. Fee and commission income and expense is specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Fee and commission income Asset management ...... 1,881 1,921 666 673 Cards ...... 6,816 7,486 2,339 2,411 Collection and payment services ...... 762 773 268 311 Derivatives ...... 127 139 36 48 Interbank clearing ...... 532 512 183 173 Lending and guarantees ...... 792 535 340 142 Security trading ...... 127 192 40 94 Other fee and commission income ...... 1,052 743 249 70 Fee and commission income ...... 12,089 12,300 4,121 3,921
Fee and commission expense Asset management ...... 136 147 55 32 Cards ...... 2,965 3,810 1,055 1,167 Collection and payment services ...... 13 21 4 7 Interbank clearing ...... 545 531 184 177 Security trading ...... 33 31 6 12 Other fee and commission expense ...... 344 187 102 51 Fee and commission expense ...... 4,036 4,726 1,406 1,446 Net fee and commission income ...... 8,053 7,574 2,715 2,475
Asset management fees are earned by the Group on trust and fiduciary activities where the Group holds or invests assets on behalf of the customers.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______17 ______Notes to the Interim Financial Statements
Net financial income
17. Net financial income is specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Dividend income ...... 24 7 3 1 Net gain (loss) on financial assets and liabilities classified as held for trading ...... (610) (879) (303) (486) Net gain (loss) on financial assets and liabilities designated at fair value through profit or loss ...... 1,077 1,220 461 871 Net financial income ...... 491 348 161 386
18. Dividend income is specified as follows:
Dividend income on trading assets ...... 15 4 - - Dividend income on financial assets designated at fair value through profit or loss ...... 9 3 3 1 Dividend income ...... 24 7 3 1
19. Net gain (loss) on trading assets and liabilities is specified as follows:
Net gain (loss) on equity instruments and related derivatives ...... (51) 157 (137) 50 Net gain (loss) on interest rate instruments and related derivatives ...... (445) (718) 9 (164) Net gain (loss) on other derivatives ...... (114) (318) (175) (372) Net gain (loss) on trading portfolio ...... (610) (879) (303) (486)
20. Net gain (loss) on assets and liabilities designated at fair value through profit or loss is specified as follows:
2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Net gain (loss) on interest rate instruments designated at fair value ...... 317 572 (56) 836 Net gain (loss) on equity instruments designated at fair value ...... 760 648 517 35 Net gain (loss) on assets and liabilities designated at fair value through profit and loss .... 1,077 1,220 461 871
Net foreign exchange gain (loss)
21. Net foreign exchange gain (loss) is specified as follows:
FX gain (loss) of loans and receivables ...... 1,851 5,410 1,527 (1,503) FX gain (loss) on bank accounts ...... 2,322 1,234 1,443 (647) FX gain (loss) from deposits and borrowings ...... (2,646) (4,455) (1,287) 1,120 FX gain (loss) from subordinated liabilities ...... (402) (725) (337) 1,098 FX gain (loss) on bonds, equity and derivatives ...... (557) 58 (670) (45) FX gain (loss) from compensation instrument ...... - 325 - - FX gain (loss) on other assets and liabilities ...... (9) 132 32 (21) Net foreign exchange gain (loss) ...... 559 1,979 708 2
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______18 ______Notes to the Interim Financial Statements
Other operating income
22. Other operating income is specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9.
Rental income from investment properties ...... 1,558 1,706 554 577 Fair value changes on investment property ...... 1,007 - 288 - Realised gain on investment property ...... 500 - 403 - Earned premiums, net of reinsurance ...... 649 651 228 224 Net gain (loss) on disposals of assets other than held for sale ...... 389 334 4 339 Other income ...... 527 787 154 21 Other operating income ...... 4,630 3,478 1,631 1,161
Personnel and salaries
23. The Group's total number of employees is as follows:
Average number of full time equivalent positions during the period ...... 1,160 1,248 1,160 1,225 Full time equivalent positions at the end of the period ...... 1,177 1,168 1,177 1,168
The Parent company's total number of employees is as follow:
Average number of full time equivalent positions during the period ...... 921 950 924 955 Full time equivalent positions at the end of the period ...... 936 870 936 870
Former employees of Verdis hf. and Sparisjódur Ólafsfjardar are included in Parent company numbers for 2012.
24. Salaries and related expense are specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Salaries ...... 6,688 6,529 1,978 2,087 Defined contribution pension plans ...... 916 881 271 281 Salary related expense ...... 1,209 811 396 337 Salaries and related expense ...... 8,813 8,221 2,645 2,705
Salaries and related expense for the Parent company are specified as follows:
Salaries ...... 5,185 4,859 1,542 1,573 Defined contribution pension plans ...... 710 656 211 212 Salary related expense ...... 968 640 316 282 Salaries and related expense ...... 6,863 6,155 2,069 2,067
Salaries and related expense from Verdis hf. and Sparisjódur Ólafsfjardar are included in Parent company numbers for 2012.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______19 ______Notes to the Interim Financial Statements
Other operating expense
25. Other operating expense: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Direct operating expense (including repairs and maintenance) derived from rental-earning investment properties ...... 364 356 117 103 Claims incurred, net of reinsurance ...... 245 267 72 56 Other operating expense ...... - 1 - 1 Other operating expense ...... 609 624 189 160
Tax expense
26. Income tax recognised in the Statement of Comprehensive Income is specified as follows:
Current tax expense Current period ...... 3,689 2,525 693 609 Deferred tax expense Changes in temporary differences ...... (314) 554 (231) (47) Total income tax expense ...... 3,375 3,079 462 562
Reconciliation of effective tax rate: 1.1.-30.9.2012 1.1.-30.9.2011
Earnings before tax ...... 17,485 18,198 Income tax using the Icelandic corporation tax rate ...... 20.0% 3,497 20.0% 3,640 Additional 6% tax on financial institutions ...... 4.1% 718 0.0% - Non-deductible expense ...... 0.1% 17 0.0% 9 Tax exempt revenues ...... (0.6%) (110) (0.4%) (52) Tax incentives not recognised in the statement of Comprehensive Income ...... (3.5%) (616) (1.3%) (243) Non-deductible taxes ...... 0.7% 131 0.0% - Other changes ...... (1.5%) (262) (1.5%) (275) Effective tax rate ...... 19.3% 3,375 16.9% 3,079
27. Bank Levy
Bank levy is calculated according to law. The levy is 0.041% on total debt excluding tax liabilities at end of period. Non-financial subsidiaries are exempt from this levy. Additional temporary levy of 0,0875% is assessed for the years 2012 and 2013 to meet the funding of a special interest relief provided to individual tax payers.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______20 ______Notes to the Interim Financial Statements
Net gain (loss) from discontinued operations net of tax
28. Net gain (loss) from discontinued operations net of tax is specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.7.-30.9. 1.7.-30.9. Net gain (loss) from legal entities ...... 903 178 3 (382) Net gain (loss) from associated companies ...... 868 - - - Net gain (loss) from other assets ...... (24) (166) 279 (51) Net gain (loss) on revaluation and disposal of real estate ...... (549) (34) (463) 214 Impairment loss on remeasurement to fair value of legal entities ...... - (2,027) - - Effect of compensation instrument ...... - 1,262 - - Net gain (loss) from discontinued operations net of tax ...... 1,198 (787) (181) (219)
Net gain (loss) from legal entities comprises the Group's share of net profit after tax from operations of legal entities that were classified as held for sale during the period.
Earnings per share Excluding Including Discontinued operations 29. Earnings per share are specified as follows: 2012 2011 2012 2011 1.1.-30.9. 1.1.-30.9. 1.1.-30.9. 1.1.-30.9.
Net earnings attributable to the shareholders of Arion Bank ...... 12,978 13,833 14,176 13,046
Weighted average share capital: ...... Weighted average number of outstanding shares for the period, million ...... 2,000 2,000 2,000 2,000
Basic earnings per share ...... 6.49 6.92 7.09 6.52 Diluted earnings per share ...... 6.49 6.92 7.09 6.52
Number of outstanding shares at the end of the period, million ...... 2,000 2,000 2,000 2,000 Number of total shares at the end of the period, million, diluted ...... 2,000 2,000 2,000 2,000
There were no instruments at period-end that could potentially dilute basic earnings per share.
Notes to the Interim Statement of Financial Position
Cash and balances with Central Bank
30. Cash and balances with Central Bank are specified as follows: 30.09.2012 31.12.2011 Cash on hand ...... 3,574 2,954 Cash with Central Bank ...... 4,890 17,686 Mandatory reserve deposit with Central Bank ...... 7,562 8,560 Cash and balances with Central Bank ...... 16,026 29,200
The mandatory reserve deposit with Central Bank is not available for the Group to use in its daily operations.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______21 ______Notes to the Interim Financial Statements
Loans and receivables to credit institutions
31. Loans and receivables to credit institutions specified by types of loans: 30.09.2012 31.12.2011 Bank accounts ...... 74,051 62,175 Money market loans ...... 10,830 4,720 Overdrafts ...... 8 19 Other loans ...... 3,895 2,963 Provision on loans and receivables ...... (777) (774) Loans and receivables to credit institutions ...... 88,007 69,103
32. Changes in the provision for losses on loans and receivables to credit institutions are specified as follows:
Balance at the beginning of the period ...... 774 1,359 Provision for losses during the period ...... 3 199 Write-offs during the period ...... - (784) Balance at the end of the period ...... 777 774
Loans and receivables to customers
33. Loans and receivables to customers specified by types of loans:
30.09.2012 Individuals Corporates Total Overdrafts ...... 17,441 17,031 34,472 Credit cards ...... 10,059 642 10,701 Mortgage loans ...... 194,228 4,790 199,018 Subordinated loans ...... - 549 549 Other loans and receivables ...... 38,215 349,335 387,550 Provision on loans and receivables ...... (22,674) (37,132) (59,806) Loans and receivables to customers ...... 237,269 335,215 572,484
31.12.2011 Overdrafts ...... 16,353 11,375 27,728 Credit cards ...... 14,679 771 15,450 Mortgage loans ...... 192,869 3,603 196,472 Subordinated loans ...... - 550 550 Other loans and receivables ...... 28,208 349,431 377,639 Provision on loans and receivables ...... (12,821) (43,468) (56,289) Loans and receivables to customers ...... 239,288 322,262 561,550
The total book value of pledged loans at 30 September 2012 was ISK 169 billion (31.12.2011: ISK 171 billion). Pledged loans at period-end comprised mortgage loans to individuals, loans to municipals and loans to state related entities that were pledged against amounts borrowed.
34. Changes in the provision for losses on loans and receivables to customers are specified as follows: 30.09.2012 31.12.2011 Balance at the beginning of the period ...... 56,289 41,843 Provision for losses during the period ...... 7,591 27,225 Write-offs during the period ...... (4,317) (13,230) Payment of loans previously written-off ...... 243 451 Balance at the end of the period ...... 59,806 56,289
Specific ...... 55,392 46,776 Collective ...... 4,414 9,513 59,806 56,289
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______22 ______Notes to the Interim Financial Statements
Financial assets and liabilities
35. Financial assets and liabilities are specified as follows: Financial assets/ 30.09.2012 Loans and Designated liabilities at receivables Trading at fair value amort. cost Total Loans and receivables Cash and balances with Central Bank ...... 16,026 - - - 16,026 Loans and receivables to credit institutions ...... 88,007 - - - 88,007 Loans and receivables to customers ...... 572,484 - - - 572,484 Loans and receivables ...... 676,517 - - - 676,517
Bonds and debt instruments Listed ...... - 3,354 42,402 - 45,756 Unlisted ...... - 62 73,879 - 73,941 Bonds and debt instruments ...... - 3,416 116,281 - 119,697
Shares and equity instruments with variable income Listed ...... - 1,338 1,364 - 2,702 Unlisted ...... - 687 8,328 - 9,015 Bond funds with variable income ...... - 2,395 1,748 - 4,143 Shares and equity instruments ...... - 4,420 11,440 - 15,860
Derivatives OTC derivatives ...... - 969 - - 969 Derivatives ...... - 969 - - 969
Securities used for hedging Bonds and debt instruments ...... - 777 - - 777 Shares and equity instruments ...... - 621 - - 621 Securities used for hedging ...... - 1,398 - - 1,398
Other financial assets ...... - - - 4,067 4,067 Financial assets ...... 676,517 10,203 127,721 4,067 818,508
Liabilities at amortised cost Due to credit institutions and Central Bank ...... - - - 16,459 16,459 Deposits ...... - - - 454,405 454,405 Borrowings ...... - - - 192,412 192,412 Subordinated liabilities ...... - - - 32,502 32,502 Liabilities at amortised cost ...... - - - 695,778 695,778
Financial liabilities at fair value Short position in bonds held for trading ...... - 11,019 - - 11,019 Derivatives ...... - 103 - - 103 Financial liabilities at fair value ...... - 11,122 - - 11,122
Other financial liabilities ...... - - - 29,705 29,705 Financial liabilities ...... - 11,122 - 725,483 736,605
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______23 ______Notes to the Interim Financial Statements
35. cont. Financial assets/ 31.12.2011 Loans and Designated liabilities at receivables Trading at fair value amort. cost Total Loans and receivables Cash and balances with Central Bank ...... 29,200 - - - 29,200 Loans and receivables to credit institutions ...... 69,103 - - - 69,103 Loans and receivables to customers ...... 561,550 - - - 561,550 Loans and receivables ...... 659,853 - - - 659,853
Bonds and debt instruments Listed ...... - 2,919 52,688 - 55,607 Unlisted ...... - 44 84,917 - 84,961 Bonds and debt instruments ...... - 2,963 137,605 - 140,568
Shares and equity instruments with variable income Listed ...... - 153 1,163 - 1,316 Unlisted ...... - 657 8,382 - 9,039 Bond funds with variable income ...... - 1,774 1,916 - 3,690 Shares and equity instruments ...... - 2,584 11,461 - 14,045
Derivatives OTC derivatives ...... - 674 - - 674 Derivatives ...... - 674 - - 674
Securities used for hedging Bonds and debt instruments ...... - 1,922 - - 1,922 Shares and equity instruments ...... - 450 - - 450 Securities used for hedging ...... - 2,372 - - 2,372
Other financial assets ...... - - - 8,004 8,004 Financial assets ...... 659,853 8,593 149,066 8,004 825,516
Liabilities at amortised cost Due to credit institutions and Central Bank ...... - - - 16,160 16,160 Deposits ...... - - - 489,995 489,995 Borrowings ...... - - - 187,203 187,203 Subordinated liabilities ...... - - - 32,105 32,105 Liabilities at amortised cost ...... - - - 725,463 725,463
Financial liabilities at fair value Short position in bonds held for trading ...... - 3,711 - - 3,711 Derivatives held for trading ...... - 1,196 - - 1,196 Financial liabilities at fair value ...... - 4,907 - - 4,907
Other financial liabilities ...... - - - 33,764 33,764 Financial liabilities ...... - 4,907 - 759,227 764,134
Included in unlisted Bonds and debt instruments designated at fair value is Drómi bond, which the Group received when acquiring deposits from SPRON hf. in March 2009.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______24 ______Notes to the Interim Financial Statements
36. Bonds and debt instruments designated at fair value specified by issuer: 30.09.2012 31.12.2011 Financial institutions ...... 69,900 70,640 Public ...... 45,152 59,368 Corporates ...... 1,229 7,597 Bonds and debt instruments designated at fair value ...... 116,281 137,605
The total amount of pledged bonds at 30 September 2012 was ISK 21.3 billion (31.12.2011: Nil).
37. Fair value hierarchy
The Group uses the following hierarchy for determining and disclosing the fair value of financial instruments by valuation technique: Level 1: quoted (unadjusted) prices in active markets for identical assets or liabilities; Level 2: valuation techniques for which all significant inputs are market observable, either directly or indirectly; and Level 3: valuation techniques which include significant inputs that are not based on observable market data.
The following table shows an analysis of financial instruments recorded at fair value by level of the fair value hierarchy:
30.09.2012 Level 1 Level 2 Level 3 Total Financial assets designated at FV through PL ...... 2,444 123,400 1,877 127,721 Financial assets held for trading ...... 6,077 4,104 22 10,203 8,521 127,504 1,899 137,924
Financial liabilities held for trading ...... 11,019 103 - 11,122
31.12.2011 Financial assets designated at FV through PL ...... 6,222 140,844 2,000 149,066 Financial assets held for trading ...... 5,391 3,181 21 8,593 11,613 144,025 2,021 157,659
Financial liabilities held for trading ...... 3,711 1,196 - 4,907
The classification of assets between financial assets between financial assets designated at fair value through profit or loss and financial assets held for trading in 2012 is consistent with the classification used in 2011.
The following table shows transfers between Level 1 and Level 2 on the fair value hierachy for financial assets and financial liabilities which are recorded at fair value:
Transfers from Level 1 to Level 2 Financial assets 30.09.2012 31.12.2011 Financial assets designated at FV through PL...... - 886
The above financial assets were transferred from Level 1 to Level 2 as they have ceased to be actively traded during the period and fair values were consequently obtained using valuation techniques using observable market inputs. There have been no transfers from Level 2 to Level 1 during the period.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______25 ______Notes to the Interim Financial Statements
37. cont. Movements in Level 3 financial instruments measured at fair value The level of the fair value hierarchy of financial instruments is determined at the beginning of each reporting period. The following table shows a reconciliation of the opening and closing amounts of Level 3 financial assets and liabilities which are recorded at fair value.
30.09.2012 31.12.2011 Balance at the beginning of the period...... 2,021 1,688 Gain (loss) recognised in Statement of Comprehensive Income...... 153 771 Acquisition...... 105 160 Disposal...... (389) (599) Transfer into Level 3...... 9 1 Balance at the end of the period...... 1,899 2,021
The following table shows the line items in the Statement of Comprehensive Income where gains (losses) related to fair value measurements in Level 3 are recognised: 30.09.2012 31.12.2011 Net interest income...... 125 176 Net financial income (expense)...... (1) 520 Net foreign exchange gain (loss)...... 29 75 Net gain (loss) recognised in the Statement of Comprehensive Income...... 153 771
Investment property Investment Investment property Total Total 38. Investment property is specified as follows: property in progress 30.09.2012 31.12.2011 Balance at the beginning of the period ...... 21,949 5,151 27,100 27,642 Additions during the period ...... 112 2,312 2,424 3,527 Disposals during the period ...... (178) (2,182) (2,360) (5,760) Transferred from property and equipment ...... - - - 775 Fair value adjustments ...... 321 686 1,007 916 Investment property ...... 22,204 5,967 28,171 27,100
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______26 ______Notes to the Interim Financial Statements
Investments in associates
39. The Group´s interest in its principal associates are as follows: 30.09.2012 31.12.2011 Audkenni hf., Borgartún 31, 105 Reykjavík, Iceland ...... 20.0% 20.0% Bakkavör Group ehf., Thorvaldsenstræti 6, 101 Reykjavík, Iceland ...... 31.3% - Farice ehf., Smáratorg 3, 201 Kópavogur, Iceland ...... 43.5% 43.5% GO fjárfesting ehf., Undirheimar, 845 Flúdir, Iceland ...... 30.0% 30.0% Hótel Borgarnes hf., Egilsgata 16, 310 Borgarnes, Iceland ...... - 20.6% Klakki ehf., Ármúli 3, 108 Reykjavík, Iceland ...... 36.3% 44.9% Kríuvarp ehf., Borgartún 35, 105 Reykjavík, Iceland ...... - 25.0% Reiknistofa bankanna hf., Kalkofnsvegur 1, 150 Reykjavík, Iceland ...... 23.3% 23.3% Reitir fasteignafélag hf., Kringlan 4-12, 103 Reykjavík, Iceland ...... 42.7% 42.7% Sementsverksmidjan ehf., Mánabraut 20, 300 Akranes, Iceland ...... 23.6% 23.6% SMI ehf., Smáratorg 3, 210 Kópavogur, Iceland ...... 39.1% 39.1% Ölgerdin Egill Skallagrímsson ehf., Grjótháls 7-11, 110 Reykjavík, Iceland ...... - 20.0%
Investments in associates are specified as follows:
Carrying amount at the beginning of the period ...... 2,987 2,713 Additions during the period ...... 24 2,854 Transferred to held for sale assets ...... - (2,525) Transferred from associates due to step acquisition ...... - (9) Impairment ...... - (54) Share of profit (loss) ...... 13 8 Carrying amount at the end of the period ...... 3,024 2,987
In May 2012 the Bank acquired 31.3% share in Bakkavör Group ehf. as a result of the conversion of the Bank´s convertible loans to equity.
In March the Bank sold its 20.6% shareholding in Hótel Borgarnes hf. The effects from the sale has minor effects on the Statement of Comprehensive Income. In June the Bank sold its 20% shareholding in Ölgerdin Egill Skallagrímsson ehf. The Group's equity interest in Klakki ehf. has been diluted from 44.9% to 36.3% following the conversion of further creditor claims on Klakki ehf. to equity shareholdings.
Tax assets and tax liabilities
40. Tax assets and liabilities are specified as follows: 30.09.2012 31.12.2011 Assets Liabilities Assets Liabilities Current tax ...... 13 2,027 6 2,284 Deferred tax ...... 462 1,193 718 1,137 Tax assets and liabilities ...... 475 3,220 724 3,421
Non-current assets and disposal groups held for sale
41. Non-current assets and disposal groups held for sale are specified as follows: 30.09.2012 31.12.2011 Legal entities ...... 3,459 8,458 Associates ...... 6,384 12,073 Real estates ...... 3,250 2,875 Other assets ...... 618 480 Non-current assets and disposal groups held for sale ...... 13,711 23,886
The legal entities are subsidiaries that were acquired exclusively with view to resale and are classified as disposal groups held for sale in accordance with IFRS 5. At period-end the largest entitiy was Fram Foods ehf. which is held by the Group's holding company Eignabjarg ehf.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______27 ______Notes to the Interim Financial Statements
41. cont. On 28 September 2011 an agreement to sell the Groups 38.9% shareholding in its associate N1 hf. was signed. A condition precedent for the sale was approval by the Icelandic Competition Authority. Approval was obtained in June 2012. The gain resulting from this transaction was ISK 868 million and is recognised in the Statement of Comprehensive Income.
On 4 October 2011 Eignabjarg ehf. signed an agreement for the sale of its 100% shareholding in B.M. Vallá ehf. A condition precedent for the sale was approval by the Icelandic Competition Authority, which was obtained in April 2012. The effects from the sale of this entity has minor effects on the Statement of Comprehensive Income.
On 15 June 2012 Eignabjarg ehf. signed an agreement for the sale of its 100% shareholding in Penninn á Íslandi ehf. A condition precedent for the sale was approval by the Icelandic Competition Authority, which was obtained in August 2012. The effects from the sale of this entity has minor effects on the Statement of Comprehensive Income.
On 3 July 2012 Fram Foods ehf. sold its subsidiary Boyfood Oy in Finland. Fram Foods ehf. is a wholly owned subsidiary of Eignabjarg ehf. The effects from the sale of this entity has minor effects on the Statement of Comprehensive Income. The associate classified as disposal groups held for sale in accordance with IFRS 5 is HB Grandi hf. At end of 2011 the Group held 20.9% effective share in Hagar hf. During the period the Group sold 15.7% effective share in Hagar hf. The gain resulting from this transaction was ISK 875 million and is recognised in the Statement of Comprehensive Income.
Real estates and other assets classified as non-current assets are generally the result of foreclosures on companies and individuals.
Liabilities associated with the legal entities held for sale are as follows: 30.09.2012 31.12.2011 Legal entities, total liabilities ...... 2,683 4,950
Other assets
42. Other assets are specified as follows: Unsettled securities trading ...... 290 708 Accounts receivable ...... 2,748 6,511 Accrued income ...... 566 455 Prepaid expenses ...... 868 678 Sundry assets ...... 702 524 Other assets ...... 5,174 8,876
Unsettled securities trading was settled in less than three days from the reporting date.
Other liabilities
43. Other liabilities are specified as follows: Accounts payable ...... 19,416 18,944 Kaupthing hf. due to investment in ABMIIF ...... - 3,048 Withholding tax ...... 462 2,186 Depositors' and investors' guarantee fund ...... 2,910 3,018 Insurance claim ...... 2,198 2,023 Unsettled securities and loans ...... 520 132 Sundry liabilities ...... 9,504 9,471 Other liabilities ...... 35,010 38,822
Unsettled securities and loans was settled in less than three days from the reporting date.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______28 ______Notes to the Interim Financial Statements
Borrowings
44. Borrowings are specified as follows: 30.09.2012 31.12.2011 Covered bonds ...... 123,894 124,524 Bonds issued ...... 6,434 - Other loans ...... 62,084 62,679 Borrowings ...... 192,412 187,203
The Group did not repurchase any own debts during the first nine months of 2012 (31.12.2011: 442 million). At the end of 2011 Arion Bank took over the issuance of covered bonds which had originally been issued by Kaupthing hf. in 2006 to 2008. The bonds in question are covered bonds amounting to ISK 119.8 billion, net outstanding, with security in mortgages and bank deposits in an institutional investment fund, Arion Bank Mortgages Institutional Investor Fund. It is a four-series issue, with two 25-year series and two 40-year series maturing in 2031, 2033, 2045 and 2048. The bonds are inflation-indexed with fixed 3.75% to 4.00% interest. Current repayment of principal is currently approximately 1.5 billion a year, currently total payment including repayment of principal, indexation and interest is 7.4 billion a year. In February 2012 Arion Bank issued covered bonds from its EUR 1.0 billion covered bond programme. The bond issue is nominated in Icelandic króna, the amount issued was ISK 2.5 billion. The covered bond issue matures in February 2034 and is inflation indexed with a fixed 3.60% interest.
In May 2012 Arion Bank completed its first non-indexed fixed rate covered bond offering, issuing ISK 1.32 billion worth of bonds in the Series Arion CB15. In June 2012 Arion Bank completed its second offering, issuing ISK 1.2 billion worth of bonds in the same series. The series was admitted for trading on NASDAQ OMX Iceland on 21 May 2012. The bonds bear 6.50% interest and mature in 2015. Book value of listed bonds is ISK 8,126 million at end of September 2012. Market value of those bonds is ISK 8,392 million. Interest of other loans is 3 month Euribor/Libor +300 bps until the loans expires in 2016. The loan can be extended up to 2022 with same terms.
Subordinated liabilities
45. Subordinated liabilities are specified as follows: 30.09.2012 31.12.2011 Tier II capital ...... 32,502 32,105 Subordinated liabilities ...... 32,502 32,105
The interest on the loan is 3 month Euribor/Libor +400 bps to the year 2015 and thereafter 3 month Euribor/Libor +500 bps.
Derivatives
46. Derivatives at fair value are specified as follows: Fair value 30.09.2012 Assets Liabilities Currency and interest rate derivatives, agreements unlisted: Forward exchange rate agreements ...... 103 21 Interest rate and exchange rate agreements ...... 441 27 544 48 Bond derivatives: Bond swaps, agreements unlisted ...... 45 53 Options - sold agreements ...... 380 2 Derivatives ...... 969 103
31.12.2011 Currency and interest rate derivatives, agreements unlisted: Forward exchange rate agreements ...... 193 671 Interest rate and exchange rate agreements ...... 463 415 656 1,086 Bond derivatives: Bond swaps, agreements unlisted ...... 18 110 Derivatives ...... 674 1,196
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______29 ______Notes to the Interim Financial Statements
Equity
Share capital and share premium
47. According to the Parent Company's Articles of Association, total share capital amounts to ISK 2,000 million, with par value of ISK 1 per share. The holders of ordinary shares are entitled to receive dividends as declared from time to time and are entitled to one vote per share at Shareholders' meetings of the Group.
Number Number (million) 30.09.2012 (million) 31.12.2011 Issued share capital ...... 2,000 75,861 2,000 75,861 2,000 75,861 2,000 75,861
Share premium represents excess of payment above nominal value that Shareholders have paid for shares sold by the Group.
Other reserves
48. Other reserves are specified as follows: 30.09.2012 31.12.2011 Statutory reserve ...... 1,637 1,637 1,637 1,637
Off Balance Sheet information
Obligations
49. The Group has granted its customers guarantees, unused overdraft and loan commitments. These items are specified as follows: 30.09.2012 31.12.2011 Guarantees ...... 10,628 8,662 Unused overdrafts ...... 34,899 34,258 Loan commitments ...... 35,262 17,687
50. Depositors' and Investors' Guarantee fund
The Group expensed ISK 683 million in the first nine months of 2012 to meet payments requirements to the Depositors' and Investors' Guarantee fund according to act no 98/1999 as amended in 2012. The Icelandic parliament has discussed a bill on a new Depositors' and Investors' Guarantee Fund, without conclusion of the matter. Due to uncertainty of the shape of future legislation the liability brought forward from previous year is not changed from the balance of ISK 2,669 million. The Group has granted the Fund a guarantee for obligations amounting to ISK 3,252 million.
Assets under management and under custody
51. Assets under management and assets under custody are specified as follows: 30.09.2012 31.12.2011 Assets under management ...... 770,692 659,024 Assets under custody ...... 1,538,934 1,716,230
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______30 ______Notes to the Interim Financial Statements
Contingent liabilities
52. Litigation is common in the banking industry due to the nature of the business undertaken. Due to the current economic climate in Iceland litigation against the Group has been uncommonly frequent. The Group has formal controls and policies for managing legal claims. Once professional advice has been obtained and the amount of loss reasonably estimated, the Group makes adjustments to account for any adverse effects which the claims may have on its financial standing. At the end of the period, the Group had several unresolved legal claims.
Legal proceedings regarding Drómi hf. One significant court case is a case between Drómi hf. and the Group. Following a decision issued by the Icelandic Financial Supervisory Authority (FME) on 21 March 2009, the Group acquired the deposits of SPRON hf. According to the decision the resolution committee of SPRON hf. is supposed to establish a specific limited liability company owned by SPRON hf., later Drómi hf., designed to receive all the assets of the savings banks and all security interests, including all liens, guarantees and other comparable interests linked to SPRON hf.’s claims. The subsidiary was then supposed to take over all SPRON hf.’s obligations to the Group relating to the acquisition of SPRON hf.'s deposit obligations and was supposed to issue a bond to the Group as compensation for the deposit obligations. This obligation to the Group was documented with an agreement on repaying the debt. The agreement states that the interest rate on the debt principal shall be determined by the FME at any given time. The FME decided that the debt should bear a given annual interest rate plus an interest premium from that time until the debt has been paid in full. It was also specified that the FME was permitted to review the decision upon request by the parties every six months. In a letter dated 2 December 2009 Drómi hf. insisted that the FME review its former interest rate decision. On 4 February 2011 the FME decided that the debt should bear an annual interest rate which should be the original given interest rate plus the original given interest premium from the takeover date until 30 June 2010, but without an interest premium from that time until the debt has been paid in full. The Group has brought legal action against the FME and Drómi hf. in an attempt to annul the FME’s decision of 4 February 2011. On 4 May 2011 Drómi hf. brought legal action against the FME and the Group. Drómi hf. principally demands the annulment of all decisions by the FME on interest rates, and secondly demands a different interest rate from the outset. In two judgments pronounced on 7 November 2012, the District Court acquitted Drómi hf. and the FME of the Group’s claims in its case, and also acquitted the Group and the FME of Drómi hf’s. claims in its case. The parties have a period of three months from the passing of the judgments to appeal them to the Supreme Court. Claims from Private Banking clients The Group has made agreements with clients of Private Banking to buy their approved claims against the estate of Kaupthing hf. The claims relate to claims for damages by clients made against the estate of Kaupthing hf. These claims were initially rejected but Kaupthing hf. has since offered these parties a settlement. The claims involved are general claims against the Kaupthing hf. estate and as a compromise to the clients, the Group has acquired the claims at 30% of the claim value and paid them immediately instead of making the clients wait until the estate has been wound up. ISK 90 million of claims have already been acquired and it is likely that a similar amount will be paid for claims which will probably be agreed to by Kaupthing hf. There is still uncertainty over the recovery of these claims from Kaupthing hf. when the company is wound up or makes composition with creditors. Legal proceedings regarding FX loans Although there is now more clarity in the matters of FX loans, due to judgments on FX loans pronounced by the Supreme Court since the Group's last interim statement, there still remains uncertainty regarding a number of issues. There are a number of court cases, to which the Group is a party, whereby e.g. the legality of the Group’s FX loans are called into question. In some cases, the interest rate which is used in the recalculation of said loans is called into question, and also if the Group is obligated to reimburse borrowers because of foreign currency linked loans which the borrower had repaid in full before the Group was founded in October 2008. If the courts side with the borrowers in the said cases, and for example, state that the Group is obligated to reimburse borrowers which had repaid before the Group was founded, the impact on the Bank’s loan portfolio would be significant.
On 21 March 2012 Hagar hf., a listed company, announced to the Icelandic Stock Exchange that it had decided to take legal action against the Group regarding Hagar hf.’s foreign currency linked loans, which it had reimbursed in full to the Group in 2009. Hagar hf.’s foreign currency linked loans were recalculated by the Group in accordance with the Group‘s notification of 15 June 2011. The outcome from the recalculation showed that the Group owed Hagar hf. approximately ISK 515 million, which the Group subsequently paid to Hagar hf. After the Supreme Court had passed its judgment of 15 February 2012, Hagar hf. expressed its view to the Group that, in light of the above judgment, Hagar hf. believed it had a further claim, amounting to ISK 824 million, against the Group regarding said foreign currency linked loans. The Group rejected Hagar hf.’s claim. Legal proceeding regarding Stefnir hf. The winding-up committee of Landsbankinn hf. has brought legal action against Stefnir hf. in Reykjavík District Court. The legal action is based on the winding-up committee’s demand to rescind Landsbankinn’s hf. payment of money market deposits which matured early in October 2008 to two funds managed by Stefnir hf. The amount involved is ISK 450 million plus interest. Stefnir hf. condsiders the winding-up committee’s claim to be baseless and the case will be heard by Rekjavík District Court in January 2013. Investigation by the EFTA Surveillance Authority Two formal investigations involving the Bank were launched by the EFTA Surveillance Authority (ESA) in 2010, which have now both been concluded.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______31 ______Notes to the Interim Financial Statements
52. cont. The first investigation, commenced in September 2010, relates to whether or not the purchases by each of the new banks, i.e. the Group, Íslandsbanki hf. and Landsbankinn hf., of assets of money market funds in the autumn of 2008 should be considered state aid under the Agreement on the European Economic Area (EEA Agreement). The Group, which was state-owned at the time, acquired assets worth ISK 7.7 billion from the funds of Rekstrarfélag Kaupthings banka hf. (now Stefnir hf.) on 30 October 2008. On 11 July 2012, ESA concluded that the Icelandic authorities had granted state aid with the acquisition by each of the new banks of the assets in the above funds. However, ESA found the aid to be compatible with the EEA Agreement as ESA considered that the Government had to implement extraordinary measures in an attempt to stabilize the economy and that the measures at issue were necessary in order to try to restore faith in the financial sector. In this respect it was necessary and appropriate to protect the investors from even greater losses on their savings.
The second investigation was launched in December 2010 and relates to the state aid granted in the restoration of certain operation of Kaupthing hf. and the establishment and capitalisation of the Group. Similar investigations were launched in relation to the restoration and capitalisation of Íslandsbanki hf. and Landsbankinn hf. In its investigation, ESA considered the appropriateness of the capitalisation measures taken by the Icelandic authorities, which were not notified to the ESA in advance of their implementation. On 11 July 2012, ESA concluded that the aid measures taken constitute state aid compatible with the EEA Agreement. In connection with this decision, the Group has undertaken certain commitments to increase competition. The Group will provide information on its website how customers can move their business to another bank. The Group has also undertaken not to acquire other financial companies until 1 of December 2014, except if it obtains the Authority´s approval beforehand. In the ESA decision, it is stated that this means that further concentration of the Icelandic financial market through acquisitions by the Group can be prevented, unless further mergers would be necessitated by financial stability considerations. The Group commits to sell, as soon as possible, shareholdings in operating companies, which have been taken over due to restructuring in line with Article 22 of the Act on Financial Undertakings No. 161/2002. The Group commits to follow the procedure and time-limits, which are set out in this provision and as interpreted by the FME. This commitment is a legal obligation already present. The Group furthermore committed to maintain up-to-date information on its website, or a subsidiary, on subsidiaries and shareholdings that are held for sale. Investigation by the Icelandic Competition Authority The Icelandic Competition Authority (ICA) has opened a formal investigation into alleged abuse of a dominant position and collusion between all card issuers in Iceland, including the Group, following a complaint by Kortathjónustan hf., a credit card payment acquirer, made in 2009. The ICA has also opened a formal investigation into the alleged abuse of their alleged collective dominant position by the three largest retail banks, including the Group. The investigation was initiated by separate complaints from BYR bank hf. and MP bank hf. made in 2010. The ICA received a similar complaint from Tryggingamidstödin hf. in 2010. The complaints from BYR bank hf. and MP bank hf. concern the terms of the banks’ mortgage arrangements, which, according to the complaint, deter individuals from moving their business to other banks and thereby restrict competition. The complaint from Tryggingamidstödin hf. concerns the banks’ alleged tying of banking services and insurances. The Group has made objections to all of the complaints. The extent of the investigations and outcome of the cases is still uncertain as well as any effect on the Group. Other matters The Group is party to a court case, whereby the claimant, a guarantor to a loan issued to the Group, claimed that the Group did not adhere to the rules of an agreement from 2001 on the use of guarantees for individual debts. According to the claimant, the Bank did not provide the claimant with a credit valuation of the debtor to be signed by the guarantor. With a judgment on 23 February 2012, the district court of Reykjavík sided with the Bank in the court case, but the claimant has appealed the judgment to the Supreme Court. The disputed amount in this case is not material for the Group but could affect the validity of guarantees held by the Group for a number of other loans to individuals.
The uncertainty regarding the book value of foreign currency lending 53. In two very similar judgments on 16 June 2010, the Supreme Court of Iceland stated that two car loans were in fact loans in Icelandic krona indexed to a foreign currency exchange rate (rather than loan agreements denominated in foreign currency) and that Act No. 38/2001 on Interest and Price Indexation made such indexation illegal. These judgments were mainly based on the wording of the respective loan documents. In a judgment on 16 September 2010, the Supreme Court of Iceland stated that a loan agreement, which was ruled to be in Icelandic krona indexed to a foreign currency exchange rate, should bear the non-indexed Icelandic krona interest rate posted by the Central Bank of Iceland. On 18 December 2010, the Icelandic Parliament passed an act (Act No. 151/2010) removing legal uncertainty on how to recalculate interest on loans in Icelandic krona indexed to a foreign currency exchange rate. According to the law, the principal of such loans shall be recalculated from the start date bearing the non-indexed interest rate for the Icelandic krona posted by the Central Bank. Furthermore, the law required that banks recalculate foreign-currency mortgage loans for personal residents before 28 March 2011. As applicable, the loan principal shall be adjusted to the outcome of the recalculation or if the borrower has overpaid, the amount shall be reimbursed. In accordance with the act, the Group recalculated all mortgage loans for personal residents in foreign currency to individuals. In two similar judgments on 14 February 2011, the Supreme Court stated that two foreign currency loans to small SMEs were in fact loans in Icelandic krona and indexed to a foreign currency exchange rate. Therefore, these loans were in breach of Act No. 38/2001 on Interest and Price Indexation. The Court passed another two similar judgments on 8 March 2011 dealing with foreign currency loans. In a ruling on 9 June 2011, the Supreme Court, by a 4-3 vote, stated that a foreign currency loan to a corporate entity was in fact a loan in Icelandic krona and indexed to a foreign currency exchange rate.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______32 ______Notes to the Interim Financial Statements
53. cont. The Group announced on 15 June 2011 that recent rulings made by the Supreme Court provide a precedent for the Group to follow, and that the loans that fall under the conditions set forth by the Supreme Court in its rulings would be recalculated. The Group has thus recalculated around 2,000 loans, to both individuals and corporates. The recalculation came in addition to the recalculation of foreign currency linked mortgage loans which was done last year. Therefore, the lion’s share of the Group’s foreign currency linked loans to individuals have been recalculated into ISK denominated loans. The first Supreme Court judgment which discussed the legality of a loan owned by the Group was pronounced on 15 June 2012, in the case Arion Bank v Háttur ehf. The case concerned the legality of the company’s loan agreement where the loan amount is specified as “the equivalent to” a certain amount in Icelandic krónur; the loan amount was disbursed to the borrower in foreign currency and the majority of the loan was repaid in foreign currency. The majority of the Supreme Court concluded that it was a legitimate FX loan, particularly with reference to the name of the loan agreement, the specification of the loan amount and interest and the way in which the loan was paid out and how repayments and interest were repaid, as it was considered that both parties had discharged their duties with amounts in foreign currencies having changed hands. The Supreme Court came to the same conclusion in a judgment pronounced on 1 November 2012, in the case of Arion Bank v P. Arnason fasteignir ehf. In that case, the loan amount is specified as “the equivalent to” a certain amount in Icelandic krónur; the loan amount was disbursed to the borrower in foreign currency, but the loan had been repaid in Icelandic krónur. In its reasoning the Supreme Court stated that according to the loan agreement between the parties, the borrower was intended to repay the loan in foreign currencies, irrespective of whether he actually did. As both parties had or were intended to discharge their duties with foreign currency changing hands, the Supreme Court considered the loan to be a legitimate loan in foreign currencies. The Group believes that comparable loan agreements with companies and individuals at the Group are subject to the precedent set by both these judgments. It is therefore clear that a decision has been reached by the courts on the legality or, in some circumstances, illegality of the majority of the Bank's FX loans to companies and individuals. However, it should be pointed out that the courts have not ruled on all types of the Bank's FX loans. On 15 February 2012, the Supreme Court passed a judgment in the case of Frjálsi fjárfestingarbankinn hf. In the judgment, it was stated that loans, which are deemed to be illegal foreign currency-linked loans, can be recalculated with the non-indexed interest rate set by the Central Bank of Iceland, however the Group cannot claim from the borrower a higher payment of interest of the loan than the interest the borrower actually paid, if the borrower has paid according to the Group‘s payment slips. As the judgment dealt with a dispute which rose from special circumstances, the Group considered precedent not entirely clear. However, the Group estimated that the loss to the Group‘s foreign loan portfolio arising from the judgment was ISK 13.8 billion. In calculating this estimate, the Group elected to follow the methodology prescribed in an impact analysis conducted by the FME. From the four scenarios prescribed in the FME’s analysis, the Group has selected the one considered to be the most plausible interpretation of the judgment. On 18 October 2012, the Supreme Court pronounced a judgment in the case Borgarbyggd v Arion Bank. The case tested some of the questions raised by the court’s judgment of 15 February 2012, including whether the principle of that case applied to legal entities. In this case the Supreme Court applied the same principle as in the judgment from February, i.e. that a financial company could not demand from the borrower higher interest that the borrower actually paid according to payment slips. This applied irrespective of whether it involved a legal entity or not. It can therefore be said that the legal uncertainty relating to the judgment from February has been significantly reduced. The aforementioned judgments, which have been pronounced since the judgment of 15 February 2012, have not affected the provision of ISK 13.8 billion. The Group issued a press release on 2 November 2012 announcing that the Group had decided to recalculate foreign currency-linked loans, which were similar to the loan disputed in the judgment of 18 October 2012. The loans in question were loans to individuals and smaller companies where there was a payment slip for payment of interest and capital in accordance with each loan’s original terms. Despite the recognition of impairment for the above estimated loss, the Group remains exposed to significant uncertainty regarding foreign currency linked loans in two respects: Firstly, the estimation uncertainty associated with the Group’s interpretation of the impact of the Supreme Court judgments of 15 February and 18 October 2012. Uncertainty exists with regard to, firstly, the Group’s preliminary determination of the specific loans that require recalculation and, secondly, uncertainty with regard to assumptions used in the method of recalculation of loans to customers that were determined to fall within the scope of the judgment. As noted above, this uncertainty is somewhat mitigated by the use of FME prescribed methodology. In the event the Group’s interpretation of the judgments of 15 February and 18 October 2012 were to change, the loss could be significantly greater or less than the current estimate of ISK 13.8 billion. Secondly, the legal uncertainty over the outcome of future legal decisions and new or amended government legislation that may require the recalculation of other categories of foreign currency loans that the Group has not previously considered as vulnerable. This will be determined by future court rulings and government actions, for which it is not currently possible to predict an outcome. Significant uncertainty exists over the impact of the above matters on the carrying value of the Bank's portfolio of foreign currency linked loans at the end of the period.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______33 ______Notes to the Interim Financial Statements
Notes to the Condensed Interim Statement of Cash Flow
54. Changes in operating assets and liabilities specified as follows: 2012 2011 1.1.-30.9. 1.1.-30.9. Mandatory reserve with Central Bank ...... 998 (20) Loans and receivables to credit institutions ...... (7,028) 6,767 Loans and receivables to customers ...... (11,539) 34,758 Bonds and debt instruments ...... 19,948 (38,936) Shares and equity instruments ...... 117 (884) Derivatives and financial liabilities at fair value ...... 5,777 69 Securities used for hedging ...... - 2,811 Other assets ...... 115 3,303 Due to credit institutions and Central Bank ...... 299 (1,234) Deposits ...... (37,839) (17,666) Borrowings ...... 1,080 1,639 Subordinated loans ...... - (1,181) Financial liabilities at fair value ...... - 698 Other liabilities ...... (3,787) (6,017) Changes in operating assets and liabilities ...... (31,859) (15,893)
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______34 ______Notes to the Interim Financial Statements
Risk Management Disclosures Further information regarding risk management is available in the annual Financial Statements 2011.
Credit risk
55. Credit risk a) Maximum exposure to credit risk
The following table shows the maximum exposure to credit risk for the components of the Statement of Financial Position at the end of the reporting period before the effect of mitigation due to collateral agreements or other credit enhancements.
Maximum exposure to credit risk related to on balance sheet assets: 30.09.2012 31.12.2011 Cash and balances with Central Bank ...... 16,026 29,200 Loans and receivables to credit institutions ...... 88,007 69,103 Loans and receivables to customers: Overdrafts...... 34,472 27,728 Credit cards...... 10,701 15,450 Mortgage loans...... 199,018 196,472 Subordinated loans...... 549 550 Other loans and receivables...... 387,550 372,534 Provision on loans and recivables...... (59,806) (51,184) Bonds and debt instruments : Listed...... 45,756 55,614 Unlisted...... 73,941 84,954 Derivatives ...... 969 674 Bonds and debt instruments, hedging, listed ...... 777 1,922 Other assets with credit risk ...... 4,067 8,004 On balance sheet maximum exposure to credit risk ...... 802,027 811,021
Maximum exposure to credit risk related to off balance sheet items: Guarantees ...... 10,628 8,662 Unused overdrafts ...... 34,899 34,258 Loan Commitments ...... 35,262 17,687 Off balance sheet maximum exposure to credit risk ...... 80,789 60,607
Maximum exposure to credit risk ...... 882,816 871,628
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______35 ______Notes to the Interim Financial Statements
55. cont. b) Credit quality by class of financial assets: Neither Past past due but Individu- due nor not ally 30.09.2012 impaired impaired impaired Total Cash and balances with Central Bank ...... 16,026 - - 16,026 Loans and receivables to credit institutions ...... 88,007 - - 88,007 Loans and receivables to customers Loans to corporates ...... 272,681 21,366 41,429 335,476 Loans to individuals ...... 191,462 20,356 25,190 237,008 Bonds and debt instruments ...... 119,697 - - 119,697 Derivatives ...... 969 - - 969 Securities used for hedging ...... 777 - - 777 Other assets ...... 4,067 - - 4,067 Total ...... 693,686 41,722 66,619 802,027
31.12.2011 Cash and balances with Central Bank ...... 29,200 - - 29,200 Loans and receivables to credit institutions ...... 69,103 - - 69,103 Loans and receivables to customers Loans to corporates ...... 274,604 17,758 46,252 338,614 Loans to individuals ...... 182,089 23,117 17,730 222,936 Bonds and debt instruments ...... 140,568 - - 140,568 Derivatives ...... 674 - - 674 Securities used for hedging ...... 1,922 - - 1,922 Other assets ...... 8,004 - - 8,004 Total ...... 706,164 40,875 63,982 811,021
c) Past due but not impaired loans by class of loans and receivables: More Up to 30 31 to 60 61 to 90 than 91 30.09.2012 days days days days Total Loans to corporates ...... 10,604 1,715 199 8,848 21,366 Loans to individuals ...... 9,404 2,329 200 8,423 20,356 Past due but not impaired loans ...... 20,008 4,044 399 17,271 41,722
31.12.2011 Loans to corporates ...... 5,649 824 834 10,451 17,758 Loans to individuals ...... 2,950 3,422 2,512 14,233 23,117 Past due but not impaired loans ...... 8,599 4,246 3,346 24,684 40,875
d) Collateral repossessed During the period, the Group took possession of real estates with the carrying value of ISK 1.226 million, all which the Group is in the process of selling, see Note 41.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______36 ______Notes to the Interim Financial Statements
55. cont. e) Loans and receivables to customers specified by sectors: 30.09.2012 31.12.2011 Individuals ...... 41.4% 39.7% Financial and insurance activities ...... 10.5% 10.8% Manufacturing, mining and other industry ...... 7.9% 7.7% Real estate activities ...... 10.6% 9.8% Agriculture, forestry and fishing ...... 9.3% 11.1% Wholesale and retail trades, transport, accommodation and food service activities ...... 11.1% 11.7% Business services ...... 5.2% 5.3% Construction ...... 1.2% 1.5% Public administration, defence, education, human health and social work activities ...... 1.1% 1.2% Other services ...... 1.7% 1.2% Loans and receivables to customers ...... 100.0% 100.0%
f) Impaired loans and receivables to customers by sector: 30.09.2012 Impaired Impaired amount loans Individuals ...... 19,994 45,184 Financial and insurance activities ...... 7,732 10,058 Manufacturing, mining and other industry ...... 2,185 9,283 Real estate activities ...... 3,513 8,682 Agriculture, forestry and fishing ...... 4,114 12,852 Wholesale and retail trades, transport, accommodation and food service activities ...... 6,577 17,904 Business services ...... 8,383 10,463 Construction ...... 1,793 5,231 Public administration, defence, education, human health and social work activities ...... 469 1,111 Other services ...... 632 1,243 Impairment on loans and receivables to customers ...... 55,392 122,011
During the period, the Group has modified its basis for determining Impaired loans and receivables to customers by sector. The cost of recalculating the comparative information on a consistent basis outweighs the benefit in the viewpoint of the Group and therefore no comparative information is presented.
In prior financial years, loans where the impairment did not exceed the remaining acquisition discount were not classified as impaired loans as the Group's management wanted to disclose impaired loan information reflecting the deterioration in loan quality subsequent to acquisition. As the Group's restructuring of acquired loans in 2008 is nearing completion, the Group's management has reclassified the remaining acquisition discount to an impairment provision.
g) Large Exposure Disclosures
A large exposure is defined as an exposure to a group of financially related borrowers which exceeds 10% of the Group’s capital base net of eligible collateral according to FME rules No 216/2007. The legal maximum for individual large exposures is 25% of capital base and the sum of all large exposures cannot exceed 400% of capital base. The maximum exposure to a group of connected clients at period-end was ISK 30 billion (31.12.2011: ISK 33 billion) before taking account of eligible collateral, excluding claim on Drómi. The Group has four large exposures at period-end (2011: five exposures) net of eligible collateral. No large exposure exceeds the legal limit of 25% of the Group's capital base at period-end. The Ministry of Finance has pledged that Arion Bank will be held harmless from the exposure due to the bond claim on Drómi. The FME has ruled that the Group can use the hold harmless statement as a credit enhancement towards the claim on Drómi ehf. Consequently, the Group finds that the net exposure on Drómi is zero.
The sum of all large exposures is 108% before collateral mitigation or 63% net of eligible collateral, which is well below the 400% legal maximum and the Group’s internal 150% limit net of collateral.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______37 ______Notes to the Interim Financial Statements
Market risk
56. Market risk a) Interest rate risk
The following table shows the sensitivity of net present value of interest bearing assets and liabilities to changes in interest rate by currency and maturity in millions of ISK in the Group. Risk is quantified by assuming a 200 bps simultaneous upward shift in all yield curves in the relevant duration band. The sensitivity does not relate to variation of annual net interest income.
30.09.2012 0-1Y 1-5Y 5-10Y 10-20Y >20Y CPI Indexed linked ...... ISK (57) (2,089) (247) (4,425) (1,295) Non Indexed linked ...... ISK (250) (791) (65) (105) (29) EUR 108 (2) - - - Other (75) (17) (101) - - 31.12.2011 CPI Indexed linked ...... ISK 40 (1,509) (1,016) (14,001) 7,684 Non Indexed linked ...... ISK (418) (1,390) (701) (265) (388) EUR 15 (5) - - - Other (27) (785) (109) - -
The table below analyses the Group’s assets and liabilities at carrying amount by residual maturity.
30.09.2012 Carrying On Up to 3 3-12 1-5 Over 5 With no Assets amount demand months months years years maturity Cash and balances with Central Bank ...... 16,026 8,617 - 7,409 - - - Loans and receivables to credit institutions ...... 88,007 73,981 13,779 - 247 - - Loans and receivables to customers ...... 572,484 5,414 45,059 69,879 238,528 213,604 - Bonds and debt instruments ...... 119,697 4,763 4,470 33 68,919 41,512 - Shares and equity instruments ...... 15,860 - - - - - 15,860 Derivatives ...... 969 - 527 (2) 444 - - Assets leg ...... 17,108 - 13,094 267 3,747 - - Liabilities leg ...... (16,139) - (12,567) (269) (3,303) - - Securities used for hedging ...... 1,398 777 - - - - 621 Investment property ...... 28,171 - - - - - 28,171 Investments in associates ...... 3,024 - - - - - 3,024 Property and equipment ...... 6,147 - - - - - 6,147 Intangible assets ...... 5,102 - - - - - 5,102 Tax assets ...... 475 - - - - - 475 Non-current assets held for sale ...... 13,711 - - - - - 13,711 Other assets ...... 5,174 64 1,489 2,009 458 47 1,107 Total assets 30.09.2012 ...... 876,245 93,616 65,324 79,328 308,596 255,163 74,218
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______38 ______Notes to the Interim Financial Statements
56. cont. Carrying On Up to 3 3-12 1-5 Over 5 With no Liabilities amount demand months months years years maturity Due to credit inst. and Central Bank ...... 16,459 11,025 3,072 2,362 - - - Deposits ...... 454,405 277,939 113,950 33,777 26,056 2,683 - Financial liabilities at fair value ...... 11,122 - 11,084 15 5 18 - Assets leg ...... (24,617) - (9,953) (188) (8,623) (5,853) - Liabilities leg ...... 24,720 - 10,018 203 8,628 5,871 - Short position bonds & derivatives ...... 11,019 - 11,019 - - - - Tax liabilities ...... 3,220 - 822 2,398 - - - Non-current liabilities held for sale ...... 2,683 - - - - - 2,683 Other liabilities ...... 35,010 1,091 4,692 21,259 2,477 188 5,303 Borrowings ...... 192,412 - 1,810 2,288 13,271 175,043 - Subordinated liabilities ...... 32,502 - - - - 32,502 - Total liabilities 30.09.2012 ...... 747,813 290,055 135,430 62,099 41,809 210,434 7,986
Off balance sheet items Guarantees ...... 10,628 2,172 917 4,833 1,372 1,334 - Unused overdraft ...... 34,899 514 5,831 14,276 14,257 20 - Loan commitments ...... 35,262 6,087 7,166 12,481 9,408 120 - Off balance sheet items ...... 80,789 8,773 13,914 31,590 25,037 1,474 -
Net interest sensitivity gap ...... 47,643 (205,212) (84,020) (14,361) 241,750 43,255 66,232
31.12.2011 Assets Cash and balances with Central Bank ...... 29,200 20,640 - 8,560 - - - Loans and receivables to credit institutions ...... 69,103 62,155 6,703 - 245 - - Loans and receivables to customers ...... 561,550 13,694 49,872 71,108 230,773 196,103 - Bonds and debt instruments ...... 140,568 3,994 515 15,256 80,125 40,678 - Shares and equity instruments ...... 14,045 - - - - - 14,045 Derivatives ...... 674 - 188 3 483 - - Assets leg ...... 9,589 - 5,603 299 3,687 - - Liabilities leg ...... (8,915) - (5,415) (296) (3,204) - - Securities used for hedging ...... 2,372 1,922 - - - - 450 Investment property ...... 27,100 - - - - - 27,100 Investments in associates ...... 2,987 - - - - - 2,987 Property and equipment ...... 6,271 - - - - - 6,271 Intangible assets ...... 4,765 - - - - - 4,765 Tax assets ...... 724 - - - - - 724 Non-current assets held for sale ...... 23,886 - - - - - 23,886 Other assets ...... 8,876 598 5,446 492 843 68 1,429 Total assets 31.12.2011 ...... 892,121 103,003 62,724 95,419 312,469 236,849 81,657
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______39 ______Notes to the Interim Financial Statements
56. cont. Carrying On Up to 3 3-12 1-5 Over 5 With no Liabilities amount demand months months years years maturity Due to credit inst. and Central Bank ...... 16,160 10,341 231 5,588 - - - Deposits ...... 489,995 377,063 58,708 24,371 27,117 2,736 - Financial liabilities at fair value ...... 4,907 - 4,492 - 415 - - Assets leg ...... (35,374) - (34,697) - (677) - - Liabilities leg ...... 36,570 - 35,478 - 1,092 - - Short position bonds & derivatives ...... 3,711 - 3,711 - - - - Tax liabilities ...... 3,421 - - 2,284 - - 1,137 Non-current liabilities held for sale ...... 4,950 - - - - - 4,950 Other liabilities ...... 38,822 2,020 8,235 20,157 2,686 219 5,505 Borrowings ...... 187,203 - 3,885 2,595 13,297 167,426 - Subordinated liabilities ...... 32,105 - - - - 32,105 - Total liabilities 31.12.2011 ...... 777,563 389,424 75,551 54,995 43,515 202,486 11,592
Off balance sheet items Guarantees ...... 8,662 343 420 1,273 5,108 1,518 - Unused overdraft ...... 34,258 808 7,685 12,465 13,272 28 - Loan commitments ...... 17,687 1 2,892 8,385 4,409 2,000 - Off balance sheet items ...... 60,607 1,152 10,997 22,123 22,789 3,546 -
Net interest sensitivity gap ...... 53,951 (287,573) (23,824) 18,301 246,165 30,817 70,065
b) Inflation risk
The Group is exposed to inflation risk when there is a mismatch between inflation linked assets and liabilities. The total amount of indexed assets amount to ISK 267.4 billion (31.12.2011: ISK 230.7 billion) and the total amount of indexed liabilities amount to ISK 223.6 billion (31.12.2011: ISK 218.5 billion).
30.09.2012 Up to 1 1 to 5 Over 5 Assets - CPI indexed linked year years years Total Loans and receivables to customers ...... 822 66,558 193,352 260,732 Bonds and debt instruments ...... - 437 988 1,425 Off balance sheet position ...... 1,998 1,526 4,896 8,420 Total ...... 2,820 68,521 199,236 270,577
Liabilities - CPI indexed linked
Deposits ...... 65,131 27,613 5,638 98,382 Borrowings ...... 2,156 9,496 110,972 122,624 Total ...... 67,287 37,109 116,610 221,006
Net on balance sheet position ...... (66,465) 29,886 77,730 41,151 Net off balance sheet position ...... 1,998 1,526 4,896 8,420 Total CPI Balance 30.09.12 ...... (64,467) 31,412 82,626 49,571 Total CPI Balance 31.12.2011 ...... (58,423) (1,448) 72,027 12,156
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______40 ______Notes to the Interim Financial Statements
56. cont. c) Currency risk Currency risk is the risk of loss due to adverse movements in foreign exchange rates. The Group is primarily exposed to currency risk through a currency mismatch between assets and liabilities. The Group has primarily managed this mismatch through the systematic redenomination of foreign currency denominated loans to customers into ISK.
Currency risk strategy The Bank's strategy towards currency risk is to meet the requirements of the Central Bank on foreign exchange balance at all times. Currency risk due to foreign currency loans to customers with ISK income will be eliminated. Net exposures per currency are monitored centrally in the Bank.
The following table shows the breakdown of assets and liabilities by currency at the end of the period: Assets ISK EUR USD CHF GBP JPY Other Total Cash with Central Bank ...... 14,332 345 231 305 500 92 221 16,026 Loans to credit institutions ...... 22,727 20,425 19,036 2,058 10,000 1,118 12,643 88,007 Loans and receivables to customers ...... 423,962 51,443 20,752 26,433 7,026 19,452 23,416 572,484 Bonds and debt instruments ...... 119,042 - 655 - - - - 119,697 Shares and equity instruments ...... 8,942 5,297 928 - 308 - 385 15,860 Derivatives ...... 904 10 - 7 28 4 16 969 Securities used for hedging ...... 1,398 ------1,398 Investment property ...... 28,171 ------28,171 Investments in associates ...... 3,024 ------3,024 Property and equipment ...... 6,147 ------6,147 Intangible assets ...... 5,102 ------5,102 Tax assets ...... 475 ------475 Non-current assets held for sale ...... 9,204 4,507 - - - - - 13,711 Other assets ...... 4,708 228 212 - 17 - 9 5,174 Total assets 30.09.2012 ...... 648,138 82,255 41,814 28,803 17,879 20,666 36,690 876,245
Liabilities and Equity Due to credit inst. and Central Bank ...... 14,136 1,615 199 - 38 235 236 16,459 Deposits ...... 374,601 22,689 15,420 5,220 6,179 1,309 28,987 454,405 Financial liabilities at fair value ...... 11,080 25 - - - - 17 11,122 Tax liabilities ...... 3,220 ------3,220 Non-current liabilities held for sale ...... 2,683 ------2,683 Other liabilities ...... 27,611 1,703 3,025 273 442 1,518 438 35,010 Borrowings ...... 130,813 2,909 20,130 20,496 7,071 10,993 - 192,412 Subordinated loans ...... - 26,031 2,482 - 3,989 - - 32,502 Equity ...... 128,432 ------128,432 Total liabilities and equity 30.09.2012 .. 692,576 54,972 41,256 25,989 17,719 14,055 29,678 876,245
Net on balance sheet position ...... (44,438) 27,283 558 2,814 160 6,611 7,012 Net off balance sheet position ...... 15,248 (18,418) 3,884 3,595 2,175 (4,166) (2,318)
Net position 30.09.2012 ...... (29,190) 8,865 4,442 6,409 2,335 2,445 4,694 Net position 31.12.2011 ...... (42,631) 8,610 9,500 9,189 2,884 5,785 6,663
Net real position 31.12.2011 ...... (24,191) 5,788 8,276 1,025 2,793 (122) 6,431
A natural hedge for currency risk is no longer relevant for the Bank.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______41 ______Notes to the Interim Financial Statements
Liquidity risk
57. Liquidity risk
The Bank’s primary source of funding is deposits from individuals, corporations and financial institutions. The Bank’s liquidity risk stems from the fact that the maturity of loans exceeds the maturity of deposits, the majority of which is on demand.
Secured liquidity The Bank calculates its secured liquidity ratio from cash on hand and cash balances with the Central Bank of Iceland, Treasury notes and Housing Fund bonds which are held specifically as liquidity reserves and other eligible assets for repo transactions with the Central Bank and compare it with the total interest bearing liabilities. The FME has set a guideline for minimum secured liquidity ratio and a minimum cash ratio. These guidelines stipulates that the Bank should have adequate liquidity reserves to withstand an instantaneous deposit outflow of 20% (Secured liquidity ratio), and that cash and cash equivalents shall amount to at least 5% (Cash ratio) of on-demand deposits. The high liquidity reserve required by the FME reflects the uncertainty of the deposit’s stickiness of the Icelandic banks and the fact that a large part of the Bank's liabilities are primarily short term or on-demand deposits while the contractual maturity of the assets is much higher. The Bank actively monitors its liquidity reserves and has made excellent progress in understanding and modelling the behaviour of its deposit base. The ratios during the period were as follows: Liquidity Cash ratio ratio Period-end ...... 31% 18% Maximum ...... 35% 23% Minimum ...... 30% 13% Average ...... 33% 18%
Deposit stickiness
The Group's deposit base has been split into seven different categories depending on its stickiness. The term stickiness of deposit defines the past stability of deposit and the projected behaviour over time. A deposit is described as being sticky if it has shown to be a stable funding for the Group in the past and is expected to remain stable in the future. Every depositor within a specific group shares common characteristics that can be used as a measure of stickiness. The criteria for different levels or categories of stickiness include, but not limited to, behaviour of depositor over time, behaviour of depositor in stressed condition, the depositors business relationship with the Group and the maturity of the deposit. These criteria's are based both on qualitative and quantitative methods. – Capital controls: Deposits from customers believed to be waiting for the lifting of capital controls; – Resolution process: Deposits from customers in a resolution process; – Investors: Deposits from investors who may withdraw when other investment opportunities appear or competitor offers higher deposits rate; – Deposits - legal entities: Deposits from legal entities with no other business relationship with the Group and not quantified as an active investor; – Deposits - retail individual: Deposits from retail individual with no other business relationship with the Group and not quantified as an active investor; – Deposits - legal entities with business relationship: Deposits from legal entities with business relationship with the Group; and – Deposits - retail individual with business relationship: Deposits from retail individual with business relationship with the Group. The table below shows the split between different levels of the Group's deposit stickiness at period-end, according to the Group’s classification. The rating 7 means the stickiest deposits and the rating 1 the least sticky.
% of deposit base: Stickiness rating 30.09.2012 31.12.2011 1 Capital controls ...... 2% 9,904 9% 43,977 2 Resolution process ...... 15% 71,661 11% 58,315 3 Investors ...... 25% 117,245 25% 124,596 4 Deposits - legal entities ...... 13% 60,163 16% 80,494 5 Deposits - retail individuals ...... 12% 54,801 11% 57,559 6 Deposits - legal entities with business relationship ...... 16% 75,772 11% 57,664 7 Deposits - retail individuals with business relationship ...... 17% 81,318 17% 83,550 Total ...... 100% 470,864 100% 506,155
The fall in deposits under Capital Controls is primarily due to a single client‘s withdrawal.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______42 ______Notes to the Interim Financial Statements
Capital Adequacy
58. Capital Adequacy Disclosures
Capital base at 30 September 2012 amounts to ISK 155,357 million. The capital adequacy ratio, calculated in accordance with Article 84 of the Act on Financial Undertakings was 22.5%, exceeding the minimum legal requirement of 8%. The Group, parent company and subsidiaries that are subjected to capital requirements rules comply in full with imposed capital requirements (31.12.2011: the same). It should be noted that the effect of a risk mitigation in the form of natural hedge, due to FX loans to borrowers with ISK income, is no longer reflected in the RWA for market risk whereas 31.12.2011 a 37% effective contribution of the corresponding portion of the FX imbalance was accounted for.
Capital Base 30.09.2012 31.12.2011 Share capital ...... 2,000 2,000 Share premium ...... 73,861 73,861 Statutory reserve ...... 1,637 1,637 Retained earnings ...... 47,126 32,950 Non-controlling interests ...... 3,808 4,110 Total Equity ...... 128,432 114,558 Deduction from Tier 1 capital ...... (5,577) (5,489) Total Tier 1 capital ...... 122,855 109,069 Tier 2 capital ...... 32,502 32,105 Total Capital base ...... 155,357 141,174
Risk weighted assets Credit risk ...... 557,607 543,233 Market risk FX ...... 29,980 31,990 Market Risk other ...... 29,455 30,757 Operational risk ...... 58,976 58,976 Total Risk weighted assets ...... 676,018 664,956 Tier 1 ratio ...... 18.2% 16.4% Capital adequacy ratio ...... 23.0% 21.2%
Official Tier 1 ratio* ...... 17.7% 16.4% Official Capital adequacy ratio* ...... 22.5% 21.2%
* Official capital ratio is based on reviewed retained earnings at 30 June 2012.
Other information
Related parties
59. The Group has a related party relationship with Kaupskil ehf., Kaupthing hf., the Group's associates, the Board of Directors of Arion Bank, the key management personnel of the Group and close family members of individuals referred to above. Icelandic State Financial Investments (ISFI, a separate state institution under the Ministry of Finance) holds a 13% stake in the Group and the Ministry of Finance is the holder of all subordinated notes that represent Tier 2 capital of the Group. Accordingly the Ministry of Finance, ISFI and government entities related to them are related parties and balances and transactions with these entities are included in the tables below under Shareholders with significant influence over the Group.
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______43 ______Notes to the Interim Financial Statements
59. cont. Balances with related parties: Net 30.09.2012 Assets Liabilities balance Shareholders with significant influence over the Group ...... - 1,767 (1,767) Shareholders with control over the Group ...... 546 62,013 (61,467) Board of Directors and key Management personnel ...... 120 107 13 Associates and other related parties ...... 57,773 15,488 42,285 58,439 79,375 (20,936) 31.12.2011
Shareholders with significant influence over the Group ...... - 1,730 (1,730) Shareholders with control over the Group ...... 493 41,376 (40,883) Board of Directors and key Management personnel ...... 104 367 (263) Associates and other related parties ...... 74,135 29,088 45,047 74,732 72,561 2,171
Events after Balance Sheet date 60. Events after Balance Sheet date In October 2012 Fram Foods ehf. sold its subsidiary Fram Foods AB in Sweden. Fram foods ehf. is a wholly owned subsidiary of Eignabjarg ehf. The the sale of this entity will have minor effects on the Statement of Comprehensive income in the fourth quarter of 2012.
Subsidiaries
61. Shares in subsidiaries in which Arion Bank held a direct interest at period-end were as follows: Equity interest Company: Country Currency accum. % AFL - sparisjódur, Adalgata 34, 580 Siglufjördur ...... Iceland ISK 94.5 EAB 1 ehf., Borgartún 19, 105 Reykjavík ...... Iceland ISK 100.0 Eignabjarg ehf., Borgartún 26, 105 Reykjavík ...... Iceland ISK 100.0 Eignarhaldsfélagid Landey ehf., Hátún 2b, 105 Reykjavík ...... Iceland ISK 100.0 Einkaklúbburinn ehf., Borgartún 19, 105 Reykjavík ...... Iceland ISK 100.0 Gen hf., Borgartún 19, 105 Reykjavík ...... Iceland ISK 100.0 GIR Fund Management Ltd., Walker House Mary Street, George Town...... Cayman Isl. ISK 100.0 Kaupthing Management Company S.A., 35a, avenue J.F. Kennedy ...... Luxemb. EUR 100.0 Landfestar ehf., Borgartún 26, 105 Reykjavík ...... Iceland ISK 100.0 NS1 ehf., Digranesgata 2, 310 Borgarnes ...... Iceland ISK 100.0 Okkar líftryggingar hf., Sóltún 26, 105 Reykjavík ...... Iceland ISK 100.0 Stefnir hf., Borgartún 19, 105 Reykjavík ...... Iceland ISK 100.0 Tekjuvernd ehf., Hlídasmári 17, 201 Kópavogur (former KB Rádgjöf ehf.) ...... Iceland ISK 100.0 Valitor Holding hf., Laugavegur 77, 101 Reykjavík ...... Iceland ISK 60.8
Arion Bank Interim Financial Statements 30 September 2012 Amounts are in ISK millions ______44 ______